Airlines Game Their Pensions by Imitating Governments - Forbes
Airlines Game Their Pensions by Imitating Governments
AMR, the parent company of American Airlines, is in bankruptcy. The Wall Street Journal reports that they are looking to discarge some pension obligations, which is common for bankrupt firms. But AMR’s pension plans are less funded than they should have been, because the government gave airlines a special break that allowed them to underfund pension plans—by mimicking the accounting practices used by state and local governments.
The key to pension funding calculations is a figure called the discount rate—essentially the inverse of an interest rate, it determines how much money you need to set aside today to cover an obligation that is due far in the future. Companies that guarantee pension benefits are generally required to use a discount rate that matches the interest rate on high-quality long-term corporate bonds, currently about 5 percent.
But in 2007, Congress passed a law (actually, they inserted a provision in the Iraq War Funding bill) that specially allowed airlines to use a discount rate of 8.25 percent. A higher discount rate means fewer assets are needed to cover a given set of benefits, and therefore lower contributions into the pension fund are required. Essentially, this law allowed cash-strapped airlines to borrow money from their pension funds to keep themselves afloat.
While a discount rate over 8 percent is irregular in the private sector, it is common among state and local governments. Indeed, 8 percent is the most commonly used discount rate among state and local pension systems in the United States, and some plans use a rate as high at 8.5 percent.
These rates assume that the plans can consistently achieve investment returns as high as 8 percent a year; while plans may achieve those rates on average, this accounting practice does not account for the fact that payouts to beneficiaries are fixed while investment returns may vary widely. (For a more detailed discussion of discount rate selection and what’s wrong with an 8 percent rate, see my National Affairs essay from last spring.)
Pension beneficiaries will bear the brunt of the pension underfunding if AMR defaults. As a Mercer consultant tells the Journal: “It allowed them to make promises they knew would be difficult to keep… It’s not fair to the employees.”
Public pension plans have a fallback that AMR does not: demanding more money from taxpayers. The usual justification for allowing high discount rates in the public sector is that governments do not go out of business; sooner or later, at taxpayer expense, they will make good on their pension promises. The trouble with that idea is that sometimes they do not.
In rare cases, municipal governments have drawn the balances of their pension funds all the way down to zero, leading them to sharply cut back pension benefits or shut them off entirely. So far, only small jurisdictions have reached this point, though some larger ones (such as Cranston, Rhode Island) are in the danger zone.
More worryingly for public employees, several states have addressed pension funding shortfalls by cutting back on previously vested benefits. In the last two years, laws enacted in Colorado, Minnesota, New Jersey, South Dakota and Rhode Island have cut back on earned pension benefits, generally by reducing or eliminating cost of living adjustments.
These laws all face court challenges, but so far they are being upheld. If these laws survive, they will demolish the assumption that public employee pensions are ironclad guarantees, and the related assumption that public employees do not need to concern themselves with the funding status of the funds that back their pensions. Governments’ apparent ability to abrogate pension obligations presents a strong argument for forcing those governments to fund their pensions adequately.
The Journal notes that Congress is considering broader relief for corporate pension sponsors, by allowing a higher discount rate despite today’s low interest rate environment. That would be a mistake. Instead, Congress should insist on conservative funding standards—for airlines, for other companies, and for state and local governments.