Airline Pilot Central

Part 2

This article is the second in a two-part series on airline pilot retirement plans. It is written from a pilot's perspective.

In this second part, Defined Benefit plans-- more popularly known as "A-plans"-- are discussed.

The article's author, Jim Magner, has extensive experience negotiating pilot retirement benefits as a retirement committee chairman for the IPA, as well as the chief negotiator for the IPA during Contract 2006 negotiations.

Defined Benefit Plans

Most people are much less familiar and comfortable with defined benefit plans ("A-plans") than with defined contribution plans. Defined benefit plans are more complicated and less intuitively understandable than defined contribution plans. To begin with, instead of individual accounts all the money in a defined benefit plan is commingled in one large trust account. Deciding how much money to put into the trust each year is much more complicated than with a DC plan. DC plans are simple, for example, 12% of your W-2 wages, capped by the government limit.

In a DB plan the administrator and actuaries have to make a series of what we hope are intelligent guesses about what the future will look like. How long will the participants live after retirement? What will the rate of inflation be in the future? How will that effect future wage increases? What will the plan earn on its investments? How long does each participant in the plan have before retirement? How many will be disabled before retirement? These and other questions have to be answered each year in order to determine the future benefits due the beneficiaries of the plan and how much must be contributed to the plan each year to fund those benefits.

In making these decisions the administrator of the plan has to operate within certain legal limits. For example, the expected rate of return on future investments cannot be set arbitrarily. There are government guidelines as to what rate of return should be used. Administrators of a plan are fiduciaries and held to a prudent man standard.

If after doing the calculations, the actuaries find that the plan has just enough money to pay its current and future obligations the plan it is fully funded. If it has more funds than required it is overfunded. If it has less it is underfunded. If the plan is overfunded, the Company is not required to contribute to the plan. Once it becomes underfunded it has an obligation to resume funding the plan.

The problem with this from the Company's point of view is that small changes in investment and actuarial assumptions can result in wide swings in a company's obligation to the plan.

Consider the following scenario. The actuaries and the administrator of the DB plan meet and decide that because of changes in the investment and financial climate it would be prudent this year to assume that inflation will be .5% higher in the future than under current plan assumption, and that because of changes in the international markets the plan will earn .75% less than was assumed in the previous set of assumptions. In addition the actuaries inform you that based on current experience, they would advise raising the average life expectancy of the group population by 4 months.

Under this new set of assumptions suddenly the plan obligations have grown tremendously. Small changes in investment and actuarial assumptions can cause huge swings in plan obligations.

The bad news is reported to the C.E.O. and the Board of Directors. Suddenly hundreds of millions of dollars in new liabilities have to be reported on the company balance sheet. This will flow through to the income and cash flow statements. In a financial environment where the investment community can severely punish those who miss their earnings targets, this can be very bad news for the stock price.

In addition, this news is likely to come at the worst possible time. Companies are subject to the business cycle. When business is good company sales and cash flow are up. The stock market does well leading to rosy investment assumptions for things like retirement plans. The company has plenty of cash at this point but it probably has to contribute very little to the retirement trust because the trust has been achieving better than expected investment returns.

Then the business cycle turns down. Business and free cash flow dry up. Investment returns are less than expected causing plan obligations to increase, etc. Now, at the worst possible moment, the company is required to place more funds in the retirement trust.

Think for a moment how different this is from the way you manage your personal finances. When times are good you put more money away. When times are bad you get through the bad times as best you can. In most cases the retirement funding system is completely opposite to the way individuals act. It often requires that businesses cough up cash in the bad times and gives them a pass in the good times when investment returns are above average and plans are technically fully funded.

You should also be familiar with how plan benefits are determined.

All defined benefit plans have a basic benefit formula. Typically it
is an earnings number such as a pilot's Final Average Earnings (FAE), multiplied by a percentage and by the years of service. My experience has been that pilots focus almost exclusively on the percentage figure. For example one will hear something like "We have a 2% A plan." The real question is, 2% of what?

The definition of FAE can vary quite a bit from plan to plan. It maybe something such as the 12 month average of the
last five twelve-month periods prior to retirement. It could be the average of the highest 3 calendar years in the last ten years prior to retirement. It could be the highest 12 calendar months in the five years prior to retirement. As you can see, the definition of FAE can make a considerable difference in the calculation of the retirement benefit.

In addition many plans contain an earnings cap. For example, the earnings may be capped at $300,000. Having the cap means the Company only has to plan to fund the defined benefit plan based on a future final average earnings of $300,000. If there were no cap the actuaries would have to assume that final average earnings would grow because of inflation at some point in the future above $300,000. Without the cap the Company would have to fund those future levels which would obviously require a greater contribution on their part. From our point of view as employees, we would like to set the cap as high as possible or, better yet eliminate it all together.

Defined benefit plans can differ considerably in how they determine years of service. Plans can count the probationary year or not count it. Time spent on sick leave or disability leave can be counted or excluded. Time spent on military leave though is always counted because of Federal law.

In addition to the basic retirement formula contained in the plan some plans contain alternate benefit formulas such as a flat dollar formula.

An example of a flat dollar formula might be that the participant would get $3,000 for each year of or fraction of years of service. A pilot with 25 years of service would get $3,000 times 25 or $75,000. Typically you figure the benefit by calculating the basic benefit formula and the flat dollar formula and than awarding the greater amount.

Why even use a flat dollar formula? The flat dollar formula allows the plan designers to avoid certain government limitations, and to place as much money as possible into the trust for the qualified plan.

There is more to evaluating a defined benefit plan than just knowing the interest rate in the formula. Not all 2% plans are necessarily better than all 1% plans. One has to calculate the basic benefit taking into account all the factors including the particular definition of years of service and longevity as well as accounting for any benefit caps in the plan to properly evaluate it.

Once the basic benefit is calculated it is necessary to calculate the normal form of benefit and any adjustment to the normal form of benefit.

In most pilot contracts the normal form of benefit is a straight life annuity. An annuity is a payment for life, and the "straight" in this term means that it is a payment only on the life of the retiree. If the pilot were single when he retires and his benefit calculation is $75,000 then he would receive one twelfth of that each month for the remainder of his life.

What if the pilot is married?

In that case he might want to provide for his spouse if he should predecease her. Even if he does not federal law requires that he choose at they least a 50% joint survivor annuity unless the spouse relinquishes the benefit in writing.

A 50% joint survivor annuity would not end when the retiree dies, but would pay 50% of the benefit to the surviving spouse until she passes on. Obviously, such a benefit with a survivorship provision is more valuable than a straight life annuity. For a married participant an actuary considers the age and sex of the spouse and the likelihood that she would predecease the retiree and reduces the benefit accordingly. A typical reduction might be 8% to 10% of the straight life annuity for spouses that are similar in age.

Most defined benefit plans offer a number of annuity options. In addition to the straight life annuity and the 50% joint survivor annuity the plan might offer a 100% joint survivor annuity or a 75% joint survivor annuity or a 50% joint survivor annuity with a 10 year period certain. The term period certain means that the benefit will be paid to the estate of the retiree should the retiree and his spouse die before the period certain has expired. As you can imagine each enhancement that increases the benefit for the spouse or the estate in the case of an annuity with a period certain further reduces the amount of the basic benefit.

Some plans also offer a lump sum option in lieu of an annuity. This is a one-time lump sum cash payment to the retiree. To determine the amount of the lump sum payment the actuary considers the average life expectancy of the people in the retirement plan and the interest rate the plan is expected to earn in future years and works backwards to determine the present value which is the amount of the lump sum payment. Another way of saying this is that the actuary answers the question "How much money would need to be invested today to pay the benefit for an average retiree?"

People make very rational decisions as to how long they will live after retirement. If a lump sum option is available people with poor health tend to choose it while those in good health with long-lived relatives tend to choose the annuity option. Because of this a lump sum option increases the cost of the plan. Offering a lump sum option can increase the cost of a defined benefit plan typically by 5% to 7%.

All defined benefit plans contain a normal retirement age, which is the age a participant can retire at with no benefit reduction. Typically, this is age 60 in pilot contracts. In some cases this can not be just an age but an age and a formula. An example, would be age 60 or an age between 55 and 60 with 30 years of service. Formulas like this are found in some labor contracts, but are rare in pilot DB plans.

What happens if the FAA raises the mandatory retirement age from 60 to 65 as now appears likely? It depends how the plan is drafted. Most plans specify a particular age, 60. If that is the case it makes no difference what the FAA does since the normal retirement age will remain at 60.

However it is possible that the plan was drafted to specify "normal retirement age" as being "FAA mandated retirement age". In this case the normal retirement age would increase along with the change in federally mandated retirement age. Check with your benefits administrator. I don't know of any plans that do this, but there could be one out there.

The next question that comes up all the time when I discuss this issue with pilots is "Sure, all the company will do is raise the normal retirement age to 65 in the next labor contract and I have to work five more years for the same benefit".

To understand why this is not the case you need to understand the concept of vesting. Vesting is a right of ownership in your retirement. ERISA, the Employee Retirement Security Act of 1974, requires 100% vesting within seven years though one year or five years is typical.

If your plan specifies age 60 for retirement and you have vested you have a right to retire at age 60. In a future contract the Company cannot ask for and the Union cannot agree to abrogate that right by agreeing to increase the normal retirement age for the years of service you have accrued. They could increase the normal retirement age for those benefits that will be earned in the future, but not for those that have already vested.

As a practicable matter changing the normal retirement age is almost never done. The plan actuaries would have to keep two benefit schedules, one at age 60 and one at age 65. Plan accounting is complicated and expensive enough as it is. If the Company wants to lower plan expenses in future years there are much easier ways to accomplish this. For example, as mentioned above, many contracts have earnings caps that are periodically increased during contract negotiations. Raising that cap less than you might otherwise would lower plan expenses without all of the expense and accounting complications of changing the normal retirement age.

If one retires prior to the normal retirement age they incur an early retirement penalty that will reduce their benefit. This makes sense since one will be drawing benefits for a longer period of time, contributions to the plan will be less and the account will have less time to grow and appreciate before retirement. A general rule of thumb is that one will lose 6% to 8% per year off of the normal benefit for each year prior to the normal retirement age. For example, if a plan has a normal retirement age of 60 and a pilot retires and begins drawing benefits at age 55 the retirement benefit would be reduced between 30% and 40% from the value of the normal benefit. Of course, the pilot could retire at age 55 and not begin drawing benefits until 60 in which case he would incur no penalty.

Many pilot DB plans have contained a provision limiting the early retirement penalty to 3% per year. This represents and increased cost to the plan and an increased benefit to plan participants.

What if the FAA raises the mandatory retirement age and a pilot chooses to work past his retirement plan's normal retirement age of 60? The pilot would of course receive an additional year of longevity up to his plan's maximum. Most pilot defined benefit plans cap the number of years of service one can accrue at either 25 years or 30 years. However, would he receive an actuarial increase because he worked past normal retirement age? This is the opposite case from an early retirement where the early retiree suffers a reduction in his benefits.

In most cases the answer is "No".  While it might not be fair, most plans usually contain a suspension of benefits clause which prohibits granting the actuarial increase to those who retire past the plans normal retirement age.

Defined benefit plans also often contain special survivor benefits that benefit the family of a participant who dies prior to retirement. These are particularly valuable to the families of younger members. An example of these might be a monthly payment to the widow of $2,500/month until the deceased would have reached normal retirement age plus an additional payment of $500/month for each child up to a maximum of three children until such time the child will have reached age eighteen.

If you think about it for a minute this looks very much like life
insurance, but it is not taxed like life insurance. We usually buy our life insurance with after tax dollars. Companies can provide a limited amount of life insurance up to certain amount tax-free, $50,000 per employee. If they provide more than that the employee is taxed on the premium the company would have paid for the excess insurance. By providing these before tax survivor benefits as part of the DB plan the employee can gain a benefit paid for with before tax dollars. This would allow him to carry less life insurance or provide a greater benefit to his family should he pass on.

Pilots are the beneficiaries of a special provision in the Federal Tax Code. The federal maximums contained in the Code are based on a normal retirement age of 65. Normally, if one retires prior to age 65, those maximums are actuarially reduced. Because pilots are forced to retire at age 60 Congress has exempted them from this provision.