Commercial Aviation: Preliminary Observations on Legacy Airlines'
Financial Condition, Bankruptcy, and Pension Issues (22-JUN-05,  
GAO-05-835T).							 
                                                                 
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'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,	 
retirees, airlines, and the PBGC.				 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-05-835T					        
    ACCNO:   A27518						        
  TITLE:     Commercial Aviation: Preliminary Observations on Legacy  
Airlines' Financial Condition, Bankruptcy, and Pension Issues	 
     DATE:   06/22/2005 
  SUBJECT:   Airlines						 
	     Bankruptcy 					 
	     Commercial aviation				 
	     Competition					 
	     Cost control					 
	     Employees						 
	     Financial management				 
	     Losses						 
	     Pensions						 
	     Retirees						 
	     Financial analysis 				 
	     Economic analysis					 
	     Business cycles					 
	     Funds management					 

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GAO-05-835T

United States Government Accountability Office

GAO Testimony

Before the Committee on Transportation and Infrastructure, Subcommittee on
Aviation

For Release on Delivery

Expected at 2:00 p.m. EDT COMMERCIAL AVIATION

Wednesday, June 22, 2005

 Preliminary Observations on Legacy Airlines' Financial Condition, Bankruptcy,
                               and Pension Issues

Statement of JayEtta Z. Hecker, Director
Physical Infrastructure Issues

and

Barbara D. Bovjberg, Director
Education, Workforce, and Income Security Issues

GAO-05-835T

[IMG]

June 22, 2005

COMMERCIAL AVIATION

Preliminary Observations on Legacy Airlines' Financial Condition, Bankruptcy,
and Pension Issues

                                 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 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 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 the level of 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.

While bankruptcy may not be detrimental to the health of the airline
industry, 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 contributions --more than some of these airlines may be
able to afford given continued losses (see figure). Various pension reform
proposals may provide some immediate liquidity relief to those airlines,
but at the cost shifting additional risk to PBGC. Moreover, legacy
airlines still face considerable restructuring before they become
competitive with low cost airlines.

20 In billions of dollars

Cash at end of 2004

15	Other obligations Operating leases

Capital leases

10

Long term debt

5 Pension obligations

0 2004 2005 2006 2007 2008

Source: PBGC and SEC filings.

                 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
advantage that may encourage other airlines sponsoring defined benefits
plans to take the same approach.

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.

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
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

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.

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 more 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.

We have previously reported that the Congress should consider broad
pension reform that is comprehensive in scope and balanced in effect.
Under current conditions, the presence of PBGC insurance may create "moral
hazard" incentives to not fund pensions knowing that PBGC will assume the
payments in the future. In considering various proposals to reform pension
requirements, the impact on airlines, PBGC, and plan participants will
vary. Nevertheless, effective reform would at a minimum include meaningful
incentives for sponsors to adequately fund their plans, provide additional
transparency for participants, and ensure accountability for those firms
that fail to match the benefit promises they make with the resources
needed to fulfill those promises.

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.

Legacy Airlines Must Reduce Costs to Restore Profitability

6Legacy 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.

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

In dollars per gallon 1.6

$1.47

1.4

1.2

1.0

0.8

0.6

0.4

0.2

0.0 1998 1999 2000 2001 2002 2003 2004 2005

Source: GAO analysis of Department of Energy's Energy Information
Administration data. Note: 2005 prices reflect average through June 7.

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.

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.

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

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.

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

14.9%

14

12

10

8

6

4

2

0 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
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.

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

Figure 6: Growth of Airline Industry Capacity and Major Airline
Liquidations Billions of ASMs, Moving Quarterly Average, 1978-2004

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 Change in

Market Year Airline Effect on passenger traffic fares

Nashville, TN 1995 American Airlines Other airlines' traffic -10.2%
eliminated hub increased. Origin and destination traffic increased.

Greensboro, 1995 Continental Lite Other airlines' traffic +5.5% NC
eliminated hub increased. Origin and destination traffic decreased.

Colorado 1997 Western Pacific Other airlines' traffic +43.6% Springs, CO
moved operations decreased Origin and to Denver destination traffic
decreased.

St. Louis, MO 2001 TWA acquired by Other airlines' traffic +5.4% American
Airlines decreased. Little change in origin and destination traffic.

Kansas City, 2002 Vanguard Airlines Little change in other airlines' +4.2%
MO suspended traffic. Little change in origin service and destination
traffic.

Columbus, 2003 America West Other airlines' traffic +3.6% OH eliminated
hub increased. Little change in

                        origin and destination traffic.

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

9Do 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.10 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 2008.11 These
estimates assume the expiration of the Pension Funding Equity Act (PFEA)
at the end of this year.12 The PFEA permitted airlines to delay 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 $2.9 billion 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 exceed total cash balances of these same legacy airlines by a
substantial amount. Legacy airlines carried cash balances of just under
$10 billion going into 2005 (see figure 7). 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. Fixed obligations
in 2008 and beyond will likely increase as payments due in 2006 and 2007
may be pushed out

10The 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.

11These 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.

12Pension 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.

and new obligations are assumed. If these airlines continue to lose money
this year as analysts predict, this picture becomes even more tenuous.

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.13

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

13SEC 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.

operating revenues. Since United terminated its pensions, Delta and
Northwest now appear to have the most significant pension funding
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. Airline management has funded
their pension plans far less than they could have. For example, PBGC
examined 101 cases of airline pension contributions from 1997 through
2002; these cases covered 18 pension plans sponsored by 5 airlines.14
During this time, $28.2 billion dollars could have been contributed to
these pension plans on a tax-deductible basis; actual contributions
amounted to $2.4 billion, or about 8.5 percent of what they could have
contributed, despite earning profits in 1997-2000 (see figure 9)15 The
maximum deductible contribution was made in only 1 of the 101 pension
contribution cases examined by PBGC. 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.

14Of 108 possible cases, 4 were eliminated because the carrier was in
bankruptcy; in 3 cases data was missing.

15Pension 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 contribution limit. In the 101 cases PBGC examined from
1997 through 2002, airlines used the highest interest rate permitted in 86
cases, and the lowest interest rate permitted in 1 case. Using the
interest rates chosen by the airlines, the maximum deductible contribution
was calculated to be $9.1 billion for these 101 cases. PBGC recalculated
the maximum deductible contribution in each case using the lowest interest
rate the airline could have chosen to determine the maximum deductible
contribution of $28.2 billion.

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

In billions of dollars

15

10

5

0

-5

-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 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.16

Other legal plan provisions and amendments, such as lump sum distributions
and unfunded benefit increases may also have contributed to deterioration
in the funding of certain plans. If large numbers of participants in an
underfunded plan elect to receive their pension benefits in a lump sum, it
can create the effect of a "run on the bank" and exacerbate the
possibility of a plan's insolvency as plan assets are liquidated more
quickly than expected. Plan funding can also be worsened by unfunded
benefit increases. When a pension plan is underfunded and the plan sponsor
is also in poor financial condition, there is an incentive, known as moral
hazard, for the plan sponsor and employees to agree to pension benefit
increases because at least part of the benefit increases may be insured by
PBGC.17

Finally, the premium structure in PBGC's single-employer pension insurance
program does not encourage better plan funding. While PBGC premiums may be
partially based on plan funding levels, they do not consider other
relevant risk factors, such as the economic strength of the sponsor, plan
asset investment strategies, the plan's benefit structure, or the plan's
demographic profile.18 In addition, current pension funding and pension
accounting rules may also encourage plans to invest in riskier assets to
benefit from higher expected long-term rates of return.19

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

16For 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).

17Currently, some measures exist to limit the losses incurred by PBGC from
newly terminated plans. PBGC is responsible for only a portion of all
benefit increases that the sponsor adds in the 5 years leading up to
termination.

18The current premium structure relies heavily on flat-rate premiums,
which are unrelated to risk. PBGC also charges plan sponsors a
variable-rate premium based on the plan's level of underfunding; however,
not all underfunded plans are required to pay it.

19In determining funding requirements, a higher expected rate of return on
pension assets means that the plan needs to hold fewer assets in order to
meet its future benefit obligations. Under current accounting rules, the
greater the expected rate of return on plan assets, the greater the plan
sponsor's operating earnings and net income. However, with higher expected
rates of return comes greater risk of investment loss.

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 full value of the benefits promised to
participants and their beneficiaries immediately prior to plan
termination. "PBGC liability" is the amount that PBGC pays after agency
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, and equals the value of the benefits that plan
participants and their beneficiaries lose when PBGC takes over a plan.

In recent pension terminations, active and high salaried employees
generally lost more of their promised benefits compared to retirees and
low salaried employees because of statutory limits. For example, PBGC
generally does not guarantee benefits above a certain amount, currently
$45,614 annually per participant at age 65.20 For participants who retire
before 65 the benefits 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 plans 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

20This 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.

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

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

Flight Attendants 5,108 29 27 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 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.

Widely reported recent large plan terminations by bankrupt sponsors such
as United Airlines and US Airways and the resulting adverse consequences
for plan participants and the PBGC have pushed pension reform into the
spotlight of national concern. The effect of various proposals to reform
pension requirements on airlines, PBGC, and plan participants will vary.
The funding relief afforded by PFEA will expire at the end of this year
and many agree that the current rules are flawed and must be fixed.
Various proposals have been made to correct these rules and shore up the
PBGC guaranteed plans, and these proposals are still being debated. The
administration has proposed tightening the funding rules among other
changes. Some of the legacy airlines with large shortfalls have endorsed
another bill in the Senate for a 25-year payback period if current plans
are frozen. However, one legacy airline that has better funded its plan,
while supporting a longer payback period, opposes freezing their plan.

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.

Concluding Observations

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.

As we have previously reported, the Congress should consider broad pension
reform that is comprehensive in scope and balanced in effect.21 Revising
plan funding rules is an essential component of comprehensive pension
reform. For example, we testified that Congress should consider the
incentives that pension rules and reform may have on other financial
decisions within affected industries. Under current conditions, the
presence of PBGC insurance may create certain "moral hazard"
incentives-struggling plan sponsors may place other financial priorities
above "funding up" its pension plan because they know PBGC will pay
guaranteed benefits. Further, because PBGC generally takes over
underfunded plans of bankrupt companies, PBGC insurance may create an
additional incentive for troubled firms to seek bankruptcy protection,
which in turn may affect the competitive balance within the industry.

In light of the intrinsic problems facing the defined benefit system,
meaningful and comprehensive pension reform is required to ensure that
workers and retirees receive the benefits promised to them. Ideally,
effective reform would incorporate many elements, among them:

21See GAO-04-90; GAO-05-108T; GAO, Pension Benefit Guaranty Corporation:
Single-Employer Pension Insurance Program Faces Significant Long-Term
Risks, GAO-03-873T (Washington, D.C.: Sept. 4, 2003); Pension Benefit
Guaranty Corporation: Long-Term Financing Risks to Single-Employer
Insurance Program Highlight Need for Comprehensive Reform, GAO-04-150T
(Washington, D.C.: Oct. 14, 2003); Private Pensions: Changing Funding
Rules and Enhancing Incentives Can Improve Plan Funding,

GAO-04-176T (Washington, D.C.: Oct. 29, 2003).

o  	improving the accuracy of plan funding measures while minimizing
complexity and maintaining contribution flexibility;

o  	revising the current funding rules to create incentives for plan
sponsors to adequately finance promised benefits;

o  	developing a more risk-based PBGC insurance premium structure and
providing incentives for sponsors to fund plans adequately;

o  	addressing the issue of underfunded plans paying lump sums and
granting benefit increases;

o  modifying PBGC guarantees of certain plan benefits;

o  	resolving outstanding controversies concerning hybrid plans by
safeguarding the benefits of workers regardless of age; and

o  	improving plan information transparency for pension plan stakeholders
without overburdening plan sponsors.

The various proposals for comprehensive reform advanced by the
Administration and various members of Congress could be a critical first
step in addressing part of the long-term stability of the private defined
benefits system. While we understand the legacy airline's liquidity
pressures and their request for assistance, the uncertain efficacy of
industry-specific relief needs to be weighed against the potential effects
on both the industry and the government. At this point, because of a lack
of a thorough understanding of those effects, particularly as they might
change under various specific legislative proposals, we would suggest
proceeding carefully, relying on sound fiduciary principles as a guide.

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]; or Barbara Bovbjerg at
(202) 512-7215 or by e-mail at [email protected]. Individuals making key
contributions to this testimony include Joe Applebaum, Paul Aussendorf,
Anne Dilger, David Eisenstadt, Charles Ford, Charles Jeszeck, Steve
Martin, George Scott, Richard Swayze, and Pamela Vines.

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