Commercial Aviation: Structural Costs Continue to Challenge	 
Legacy Airlines' Financial Performance (13-JUL-05, GAO-05-834T). 
                                                                 
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.				 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-05-834T					        
    ACCNO:   A29757						        
  TITLE:     Commercial Aviation: Structural Costs Continue to	      
Challenge Legacy Airlines' Financial Performance		 
     DATE:   07/13/2005 
  SUBJECT:   Airlines						 
	     Bankruptcy 					 
	     Commercial aviation				 
	     Competition					 
	     Cost analysis					 
	     Cost control					 
	     Economic analysis					 
	     Financial analysis 				 
	     Losses						 
	     Pensions						 
	     Transportation industry				 

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GAO-05-834T

United States Government Accountability Office

GAO Testimony

Before the Committee on Commerce, Science, and Transportation,
Subcommittee on Aviation, U.S. Senate

For Release on Delivery

Expected at 10:00 a.m. EDT COMMERCIAL AVIATION

Wednesday, July 13, 2005

 Structural Costs Continue to Challenge Legacy Airlines' Financial Performance

Statement of JayEtta Z. Hecker, Director Physical Infrastructure Issues

GAO-05-834T

[IMG]

July 13, 2005

COMMERCIAL AVIATION

Structural Costs Continue to Challenge Legacy Airlines' Financial Performance

                                 What GAO Found

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 (see figure). 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.

                 United States Government Accountability Office

Mr. Chairman and Members of the Subcommittee:

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.1 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,2 eventually terminating their pension plans
and passing the unfunded liability to the Pension Benefit Guaranty
Corporation (PBGC).3 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

1While there is variation among airlines in regards to the size and
financial condition, we adhere to a construct adopted by industry analysts
to group large passenger airlines into one of two groups-legacy and low
cost. Legacy airlines (Alaska, American, Continental, Delta, Northwest,
United, and US Airways) predate airline deregulation of 1978 and have
adopted a hub and spoke network model that can be more expensive to
operate than a simple point-to-point service model. Low cost airlines
(AirTran, America West, ATA, Frontier, JetBlue, Southwest, and Spirit)
have generally entered the market since 1978, are smaller, and generally
employ a less costly point-to-point service model. The 7 low cost airlines
have consistently maintained lower unit costs than the 7 legacy airlines.

2Two other smaller carriers-ATA Airlines and Aloha-are also in bankruptcy
protection. Hawaiian Airlines just emerged from bankruptcy protection
earlier this month.

3The Pension Benefit Guaranty Corporation's (PBGC) single-employer
insurance program is a federal program that insures certain benefits of
the more than 34 million worker, retiree, and separated vested
participants of over 29,000 private sector defined benefit pension plans.
Defined benefit pension plans promise a benefit that is generally based on
an employee's salary and years of service, with the employer being
responsible to fund the benefit, invest and manage plan assets, and bear
the investment risk. A single-employer plan is one that is established and
maintained by only one employer. It may be established unilaterally by the
sponsor or through a collective bargaining agreement.

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.4 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.5 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.

In summary:

o  	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.

o  	Bankruptcies are endemic to the airline industry, the result of
longstanding structural issues within the industry, but there is no clear

4U.S. Government Accountability Office, COMMERCIAL AVIATION: Legacy
Airlines Must Further Reduce Costs to Restore Profitability (GAO-04-836)
August, 2004.

5We found all relevant data for assessing the financial condition of the
airline industry, analyses of the effects of bankruptcy on the industry as
a whole and six case studies of hub markets affected by airline bankruptcy
or service withdrawals, interviews with industry and subject area experts,
and analyses of SEC and PBGC data to be sufficiently reliable for our
purposes.

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.

o  	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.

Legacy Airlines Must Reduce Costs to Restore Profitability

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).6 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.

Figure 1: Average Annual Spot Price for Gulf Coast Jet Fuel, 1998-2005

               Note: 2005 prices reflect average through June 7.

6 Legacy airlines' fuel costs as a percentage of total operating costs
doubled from 11.5 percent during the 4th quarter of 1998 to 22.9 percent
during the 4th quarter of 2004. Fuel costs for these airlines were $5
billion higher in 2004 than in 2003 - an amount roughly equal to their net
operating losses.

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.

Figure 2: Percentage Change in Passenger Yields Since 2000

Percentage change 0

-2

-4

-6

-8

-10

-12

-14

-16

-18 2000 2001 2002 2003 2004

Legacy airline yields

Low cost airline yields Source: GAO analysis of Department of
Transportaion (DOT) Form 41 data.

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.

Figure 3: Legacy vs. Low Cost Airline Unit Cost Differential, 1998 2004

In dollars per available seat mile 0.12

0.11

0.10

0.09

0.08

0.07

0.06

0.00

                       1998 1999 2000 2001 2002 2003 2004

Legacy airlines

Low-cost airlines Source: GAO analysis of DOT Form 41 data.

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.

Figure 4: Airline Operating Profits and Losses, 1998-2004

In billions of dollars 8

6

4

2

0

-2

-4

-6

-8

-10 1998 1999 2000 2001 2002 2003 2004

Legacy airline

Low cost airline Source: GAO analysis of DOT Form 41 data.

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

Bankruptcy is Common in the Airline Industry, but There is No Evidence
that it is Harmful to the Industry or Competitors

high fuel prices-operating profitability, excluding fuel costs, is as high
as it has ever been for the industry.

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.7 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.

7Airlines may file for two types of bankruptcy. Chapter 7 of the
bankruptcy code governs the liquidation of the debtor's estate by
appointed trustees of the court. Chapter 11 of the code governs business
reorganizations and allows, among other things, companies to reject
collective bargaining agreements and renegotiate contracts and leases with
creditors with the approval of the court. Companies may also convert from
a Chapter 11 reorganization into a Chapter 7 liquidation or may liquidate
within Chapter 11.

Figure 5: Comparison of Airline and Overall Business Failure Rates,
1984-1997

Failure percentages 16 14 12 10

                                       8

                                       6

                                       4

                                       2

                                       0

14.9%

1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Year

                              Overall failure rate

Airline failure rate Source: GAO analysis of DOT and Dun & Bradstreet
data. Note: Dun & Bradstreet data were only available through 1997.

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.8 More recently, airline executives

8The National Commission to Ensure a Strong Competitive Airline Industry,
Change, Challenge, and Competition, A Report to the President and
Congress, August 1993.

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.9

9Conversely, consolidation within the industry may help remove some
capacity. The pending merger between America West and US Airways
contemplates an airline with approximately 10 percent less total capacity
than what the two carriers now operate independently. The U.S. federal
government will own a significant stake in the merged company: the Air
Transportation Stabilization Board will own 11.2 percent of the company,
and the PBGC will own at least 5 percent.

Figure 6: Growth of Airline Industry Capacity and Major Airline
Liquidations Billions of ASMs, Moving Quarterly Average, 1978-2003

350 300 250

200 150 100

50

0 Quarter

Recession Source: Bankruptcy filings, media reports, and DOT Form 41 data.

Note: Figure does not show liquidations of smaller 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.

Table 1: Case Examples of Markets' Response to Airline Withdrawals

Market     Year Airline        
Nashville, 1995 American       
TN              Airlines       
                   eliminated hub 

Greensboro, 1995 Continental Lite NC eliminated hub

Colorado 1997 Western Pacific

Springs, CO 	moved operations to Denver

St. Louis, 2001 TWA acquired MO by American Airlines

Kansas City, 2002 Vanguard

MO 	Airlines suspended service

Columbus, 2003 America West OH eliminated hub

Effect on passenger traffic

Other airlines' traffic increased. Origin and destination traffic
increased.

Other airlines' traffic increased. Origin and destination traffic
decreased.

Other airlines' traffic decreased Origin and destination traffic
decreased.

Other airlines' traffic decreased. Little change in origin and destination
traffic.

Little change in other airlines' traffic. Little change in origin and
destination traffic.

Other airlines' traffic increased. Little change in origin and destination
traffic.

Change in fares

-10.2%

+5.5% +43.6%

+5.4% +4.2%

+3.6%

Source: Intervistas/GA2.

Note: Little change in traffic means that traffic increased or decreased
less than 5 percent and that origin and destination traffic increased or
decreased less than 10 percent. Changes in passenger traffic and fares are
measured from 4 quarters prior to the airline departure to 8 quarters
after.

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.10 Another study came to a similar conclusion in 2000,
this time examining the operating performance of 51 bankrupt firms,
including

10Do Airlines In Chapter 11 Harm Their Rivals?: Bankruptcy and Pricing
Behavior in U.S. Airline Markets, National Bureau of Economic Research
Working Paper 5047, Severin Borenstein and Nancy L. Rose, February 1995.

Legacy Airlines Face Significant Near-term Liquidity Pressures, including
$10.4 Billion in Pensions Contributions over the Next 4 Years

5 airlines, and their competitors.11 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.

Under current law, legacy airlines' pension funding requirements are
estimated to be a minimum of $10.4 billion from 2005 through 2008.12 These
estimates assume the expiration of the Pension Funding Equity Act (PFEA)
at the end of this year.13 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

11The Effect of Bankruptcy Filings on Rivals' Operating Performance:
Evidence From 51 Large Bankruptcies, Robert E. Kennedy, International
Journal of the Economics of Business; Feb. 2000; pp. 5-25.

12These estimates include only legacy airlines that continue to sponsor
defined benefit pension plans and reported their estimated pension
obligations to PBGC. Pension law provisions prohibit publicly identifying
the airlines that have reported this information.

13Pension Funding Equity Act of 2004 (P.L. 108-218, April 10, 2004). The
PFEA also changed the interest rate used to calculate future liability
from the 30-year Treasury bond to a corporate bond rate, which effectively
reduces future liabilities.

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.

Figure 7: Comparison of Legacy Airline Year-end 2004 Cash Balances with
Fixed Obligations, 2005-2008

In billions of dollars

20

15

10

5

0 2004 2005 2006 2007 2008

Cash at end of 2004 Other obligations

Operating leases

Capital leases

Long term debt

Pension obligations Source: PBGC and SEC filings.

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.14

Figure 8: Funded Status of Legacy Airline Defined Benefit Plans, 1998-2004

           In billions of dollars 1998 1999 2000 2001 2002 2003 2004

                      Source: GAO analysis of SEC filings.

Note: The termination of the United Airlines and remaining US Airways
defined benefit pension plans in 2005 reduced the total shortfall to
approximately $13.7 billion, based on 2004 year-end data.

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

14SEC data and PBGC data on the funded status of plans can differ because
they serve different purposes and provide different information. The PBGC
report focuses, in part, on the funding needs of each pension plan. In
contrast, corporate financial statements show the aggregate effect of all
of a company's pension plans on its overall financial position and
performance. The two sources may also differ in the rates assumed for
investment returns on pension assets and in how these rates are used. As a
result, the information available from the two sources can appear to be
inconsistent. PBGC data also are not timely. For more information, see
GAO, Private Pensions: Publicly Available Reports Provide Useful but
Limited Information on Plans' Financial Condition (GAO-04-395) March 31,
2004.

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.

o  	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.

o  	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.15 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).16 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.

15These 101 cases covered 18 pension plans sponsored by 5 airlines.

16Pension funding rules permit sponsors to choose the interest rate used
to determine the maximum deductible pension contribution permitted from an
interest rate "corridor" - a limited range of interest rates. In
calculating the maximum deductible contribution, a higher interest rate
produces a lower deductible contribution limit. The maximum deductible
contributions referred to in this paragraph and figure 9 are calculated
using the lowest interest rate permissible from the interest rate
corridor.

Figure 9: Comparison of Legacy Airline Pension Maximum and Actual
Contributions and Operating Profits, 1997-2002

In billions of dollars

15 -10

                   1997 1998 1999 2000 2001 2002 Fiscal year

                              Actual contribution

                                Maximum possible

                             Operating profit/loss

                             Source: PBGC and DOT.

o  	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.17 Other
lawful plan provisions and

17For further information, see U.S. Government Accountability Office,
PRIVATE PENSIONS: Recent Experiences of Large Defined Benefit Plans
Illustrate Weaknesses in Funding Rules, GAO-05-294, (Washington, D.C.: May
31, 2005).

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).

Table 2: Airline Pension Termination Information (in millions of dollars)

                     Fiscal year of                                 Estimated 
                               plan  Benefit       PBGC Net claim participant 
             Airline  terminations  liability liability   on PBGC      losses 
             Eastern           1991   1,686       1,574       530         112 
               PanAm   1991, 1992     1,267       1,212       753 
                 TWA           2001   1,729       1,684       668 
          US Airways   2003, 2005     7,900       5,926   3,026         1,974 
              United           2005  16,800      13,600   6,600         3,200 

Source: PBGC.

Note: "Benefit liability" is the value of the benefits promised to
participants and their beneficiaries immediately prior to plan
termination. "PBGC liability" is the amount that PBGC pays after statutory
guarantee limits are imposed. "Net claim on PBGC" is the difference
between the PBGC liability and the assets PBGC obtains from the plan.
"Estimated participant losses," the difference between the Benefit
Liability and the PBGC liability, equals the value of the benefits that
plan participants and their beneficiaries lose when PBGC takes over a
plan.

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. 18 For participants who retire

18This guarantee level applies to plans that terminate in 2005. The amount
guaranteed is adjusted (1) actuarially for the participant's age when PBGC
first begins paying benefits and (2) if benefits are not paid as a
single-life annuity. Because of the way the Employee Retirement and Income
Security Act of 1974 (ERISA), as amended, allocates plan assets to
participants, certain participants can receive more than the PBGC
guaranteed amount.

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.

Table 3: United Airlines Active Employee Pension Termination Benefit Cuts

                             Extent of benefit cut

Plan

                Active employees in plan Actives employees with benefits cuts

                                   1% to <25%

>25% to <50% >50%

Management,
Administrative, and
Public Contact
Employees 20,784 19,231 1,696 15,885 1,650

               Ground Employees 16,062 16,062 11,448 3,441 1,173

               Flight Attendants 15,024 11,109 1,305 7,067 2,737

                      Pilots 7,360 7,270 3,927 2,039 1,304

Source: PBGC.

Note: Calculation estimates made with 1/1/2005 seriatim data

  Table 4: United Airlines Retiree Pension Termination Benefit Cuts Extent of
                                  benefit cut

Plan

Retirees in plan

                          Retirees with benefits cuts

>1% to <25%

>25% to <50% >50%

Management,
Administrative, and
Public Contact
Employees 11,360 2,996 2,816 104 76

                   Ground Employees 12,676 4,961 4,810 121 30

                       Flight Attendants 5,108 29 27 1 1

                        Pilots 6,087 3,041 1,902 975 164

Source: PBGC.

Note: Calculation estimates made with 1/1/2005 seriatim data

It is important to emphasize that relieving legacy airlines of their
defined benefit funding costs will help alleviate immediate liquidity
pressures, but

Concluding Observations

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.

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 [email protected]. Individuals making key
contributions to this testimony include Paul Aussendorf, Anne Dilger,
Steve Martin, Richard Swayze, and Pamela Vines.

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