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The question often comes up, what happens if the FAA retirement age is
raised to 65? Will this provision be repealed? In all likelihood the
answer is that it probably will be.
Will this result in a reduction in pilot retirement benefits? The
answer is probably not. To begin with most pilot plans do not pay
anywhere near the maximum benefit allowed under current statute. The
maximum defined benefit this year is $185,000. However some of those
airlines with larger A Plans such as FedEx could bump up against this
limit. If we were to assume the worst case scenario that the maximum
federal limit would be reduced by 40% (8% per year) at age 60 this
would reduce the $185,000 limit to $111,000. In that case the
non-qualified portion of the retirement plan would make up the
difference if the plan has one and most plans do. That is why it was
drafted into the plan for in the first place. In other words, the pilot
would still get the same retirement benefit
as before, but now a small part of that benefit would be paid out of the less secure non-qualified portion.
How much are Defined Benefit Plans worth?
This is a question most people have great difficulty with and pilots,
though they have higher educational standards than the general
population, are no exception. Our brains do no not have an intuitive
sense of the questions involving the time value of money.
One way to answer the question is to ask how much money one would have
to pay an insurance company to sell you an annuity equal to your
retirement? What the insurance company does when you buy an annuity is
guess how long you are going to live on average. They then figure how
much they can make by investing in high quality long term bonds. They
add in a little bit for their profit, after all someone has to pay for
all those impressive buildings they own, and they quote you a price.
Obviously the price will vary depending on how they evaluate the state
of your health, and the current market rate for high quality bonds. If
bonds are yielding a higher interest rate you'll be able to get a
better deal on the annuity.
There are a number of web sites that allow you to purchase annuities on
line. It might be worth your time to visit one to get an idea of how
much a stream of payments for life would cost if you instead of your
company had to buy it.
I recently went to the web site immediateannuities.com
and found that under current market conditions a straight-life annuity
paying $75,000/year for a male retiring at 60 would cost a little over
a million dollars. Most people when asked to guess the cost of a
$75,000 retirement would guess much less.
In studies employees, even highly educated ones like pilots, always
underestimate the value and cost of retirement benefits. When you think
about it many of us will spend a longer time in retirement than we did
working for our airline. There was a time in the 70's when one had to
be hired by 30 to have any hope of getting on with the majors. These
days many folks are in their late thirties or even early forties before
they land a job with a top-tier carrier. At the legacy carriers the
cost of retirement benefits were equal to twenty to twenty-five percent
of the cost of payroll before the recent spate of pension terminations.
Today at many carriers it is more like 10% of payroll. When you put
this together with shorter careers you have the makings of a pension
disaster.
You may remember that earlier in the article we said that if you had a
million dollars in your DC plan you could invest it and withdrawal 4%
or $40,000 per year. We just mentioned that with the annuity an
insurance company would pay you $75,000 per year. Why the difference?
Well for one thing the 4% withdrawals from the DC plan are
periodically adjusted for inflation. The annuity is not. Its payment remains fixed no matter what inflation does.
Secondly, the insurance company issuing the annuity places you in with
a pool of retirees. Their actuaries can predict with great precision
the average life expectancy of the people in the pool. You as an
individual though don't know if you will live 40 years past retirement
or only one day past your retirement date. Prudence demands that we
plan for a longer than average retirement and lower our withdrawal rate
from our IRAs because half us will beat that average life span that
insurance company is counting on.
Distress Terminations
Defined benefit retirement plans sometimes end. If the plans are fully
funded money is paid out to the participants, who can then roll that
money over into an IRA. This is called a standard termination.
In a distress termination the DB plan's assets are taken over by the
Pension Benefit Guarantee Corporation. This has been an all too
frequent event in the airline industry in recent years.
For a distress termination to occur two conditions must exists. The
plan must be underfunded and the company must declare bankruptcy.
The Pension Benefit Guarantee Corporation, PBGC, is an independent
agency of the Federal Government that insures defined benefit
retirement plans. The PBGC collects premiums from retirement plans and
in a distress termination will take over the plan and pay out a limited
amount of benefits to the participants.
For those who retired at 65 the maximum benefit the PBGC will pay is
$49,500. It is around $29,000 for those who retire at age 60.
Cash Balance Plans
Cash balance plans are another type of retirement plan you should be
familiar with. A cash balance plan is a defined benefit plan that looks
like a defined contribution plan.
In a cash balance plan the plan sponsor, the employer, contributes a
percentage of the employee's salary to the plan trust each year. The
employer guarantees that the money in the trust will grow by a certain
percentage or by a particular index such as the Treasury Bill Index or
the S&P 500 index. Since the employer guarantees the return and
takes the investment risk this is considered a defined benefit plan. In
reality though the employer does not take much of a risk at all. The
employer either chooses a very low interest rate, which is easy to
meet, say 4%, or chooses an index and invests the money in an index
fund that mirrors that index. In any case the risk to the employer is
minimal which allows them to avoid any earnings surprises like they
might with a traditional DB plan. When the employee reaches normal
retirement age and retires the amount due the employee from the cash
balance plan is then used to purchase an annuity for the employee.
The cash balance plan can create virtual accounts for each employee. To
the employee this looks like an individual account much like they have
in a DC plan though in reality the money is all commingled in the
trust. Also like a DC plan the cash balance plan is almost always 100%
funded. This means that in case of a bankruptcy filing there is
unlikely to be a distress termination.
Unlike a defined contribution plan the participant has no investment choices. The
plan pays whatever the interest rate or index that was specified when
the plan was established. Since these are usually very conservative
rates of return or indexes the plans tend to have marginal investment
performance. Also it is hard to meet the needs of a diverse employee
group by having only one investment option.
Also unlike a traditional defined benefit plan cash balance plans do
not offer an early retirement option. If you leave early the value of
your payout is whatever is in your virtual account. These plans also
traditionally lack the survivorship and lump sum options that many
traditional DB plans incorporate.
Companies have rushed to convert their traditional defined benefit to
cash balance plans in recent years. Though they are not common in the
airline industry over twenty percent of existing defined benefit plans
have been converted to cash balance plans. This has usually been done
to the detriment of the older participants in the plan. When a
conversion takes place older workers almost always fair more poorly
under the cash balance plans than they would have under the traditional
defined benefit plans. This practice has been challenged in court and
there have been a series of conflicting court decisions in the matter.
Congress addressed some of the problems in the recently
passed Pension Protection Act of 2006 though any attempt by a company
to convert a traditional DB plan to cash balance plan should still be
viewed with suspicion.
The future of airline pensions
To consider where we are going let's begin by looking back at where we
have been.
Pilots have been and are today highly paid workers that have a limite
and fragile career. Typically they learn their profession by spendin
years of apprenticeship in the military or in low paying civilian job
before being hired by an airline. They have also been required to end
their careers earlier than other workers either through government
mandated retirement or through involuntary medical retirement.
To meet the needs of this group, pilot unions have traditionally
been
able to negotiate retirements that pay 50-60% of a pilot's final
average earnings at 25 years of service. It was assumed that Social
Security and personal savings would supplement this company provided
retirement to allow a retirement of approximately 80%-85% of the
retiree's working income.
Defined benefit plans were the preferred way of providing this
benefit.
Defined benefit plans offered professional investment advice and
management. This was seen as a necessity as it was thought that wise
investing was beyond the capability of many employees. Also in a
prederegulation marketplace rates of return were modest for the
airlines, but bankruptcy was a rare event.
In 1978 deregulation was passed and things changed. Airline
transportation was no longer seen as a quasi-utility requiring
government regulation for the public good. Critics of deregulation said
that the airlines would engage in ruinous competition. Proponents
of deregulation said consumers would benefit. Both were right. Over the
years the legacy carriers have been liquidated to the detriment of
their employees, stockholders and creditors, but consumers have
undoubtedly paid less for their air transportation than they would have
under the regulated system.
Four years prior to deregulation Congress had passed ERISA to correct
pension abuses and shore up private pensions. It was better than what
existed before, but it ultimately proved inadequate.
Since the advent of deregulation thirty years ago almost every legacy
carrier has been liquidated through bankruptcy or had their defined
benefit retirement plans liquidated and the liabilities of those plans
passed on to the PBGC. The one lone exception to this has been American
Airlines.
Maybe B plans are the solution? Defined contribution plans have
increased in the air transport industry. This mirrors the trend in our
national economy where there has been a rush to convert of or get rid
of DB plans and replace them with DC plans. Worse yet in many cases
companies have replaced defined contribution plans with 401k plans that
have low company matching or no company match at all. This certainly
makes companies more competitive, but it will eventually lead to a
generation of American workers that will have much less prosperous
retirement than those generations that came before them.
From our perspective as pilots there are two problems with replacing
defined benefit plans with defined contribution plans. The first
problem as was mentioned earlier is that some folks are extraordinarily bad at managing money. In any investor population there
are some people that don't have the interest or the talent to do well
in financial matters. Pilots as a group are no exception. Any
retirement plan that relies solely on DC plans to fund retirement is
likely to have a significant percentage of its retirees reduced to
poverty by the end of their retirement.
Now when I mention this, one response I always get from pilots is "So
what!" "If they made bad decisions it's their own fault!" This kind of
comment usually comes from younger folks. At thirty everyone believes
himself or herself to be an investment genius, or at least not an
investment incompetent. Age and experience tends to temper one's view
of their investment abilities. In fact it has been my experience that
the greater an investor's confidence in the their investing abilities
at an early age the least likely they are to achieve that investment
success. More investors are ruined by overconfidence and greed than by
caution.
Everyone believes that the train wreck is going to happen to the other
guy. However if you found yourself vigorously agreeing with the
proposition "it's their own fault" in the previous paragraph. You might
want to consider that you just might be the next train wreck that is
getting ready to happen.
When designing retirement plans we have to face the reality that a
retirement design that relies solely on DC plans is likely to fail to
meet the needs of a significant number of its participants.
The second problem with the DC plans is that because of limits on how
much the government will allow you to contribute to your B plan. In
most cases it is not enough to fund an adequate retirement.
How about defined benefit plans? Can they be fixed?
The problem with defined benefit plans is bankruptcy and under-funding
the plans. These are the two conditions that must exist before a
company can shed their DB plan obligations through a distress
termination.
There is no way we can prohibit companies from filing for bankruptcy,
but it would be possible to raise the status defined benefit plans
receive in bankruptcy court. Putting them ahead of certain other
classes of creditors would place them in a more secure position. One
could also raise the limits on the insurance coverage provided by the
PBGC. These coverage limits are not indexed for inflation and have not
grown in years.
Unfortunately, I don't believe that we have a very good chance of
convincing Congress to act on either of these issues. Congress is
unlikely to raise the limits of coverage provided by the PBGC when that
agency is already under so much stress just trying to pay the claims it
has had dumped on it at today's very low limits. It would also be very
difficult to convince Congress to amend the bankruptcy statutes to
provide us a higher status in bankruptcy proceedings.
Congress has dealt with some of the funding issues in legislation
passed last year. They could do more. Congress could require that
companies overfund DB plans up to a certain level, say 20%. This would
smooth out some of the peaks and valleys that now exist in funding
defined benefit plans. In return they could mandate more level funding
requirements to dampen out the boom bust cycle that companies now often
find themselves under the current rules.
There has been one set of airline defined benefit plans that has done
superbly well during the numerous airline bankruptcies of the past
several decades. Those are the defined benefit plans belonging to
airline executives. To my knowledge though tens of thousands of airline
employees have had their pensions reduced and stripped away through
bankruptcy filings not one airline president has lost a dime
out of their pension plans. For some reason when it comes time to file for bankruptcy their plans are always fully funded.
This is completely unconscionable. What we are running here is two
separate and very unequal sets of retirement rules. One set of rules
exists for the guys at the top. There is different and much less
lucrative set for the rest of us.
The single most effective thing that Congress could do to guarantee
defined benefit retirement plans would be adequately funded would be to
require that plans of workers and upper management be commingled. Right
now management has no real incentive to adequately fund workers'
pensions. Why should they? The law allows them to have very rich and
very well funded plans that are completely separate from those of their
employees. Coupled with the use of the bankruptcy code this creates a
moral hazard that almost irresistibly compels management to renege on
their retirement promises. Why shouldn't they? Congress has made it so
easy for them.
This is a great issue for workers, for pilots, for unions. The basic
unfairness of what has happened to workers' pensions in the airline
industry while management has suffered not at all is manifest and
simply understood by the public. The solution of commingling pensions
is simple and easily understood. Simple sells! If the CEO's pension is
fully funded ours will be also if we are in the same plan. If not than
we are both subject to the inadequate and meager coverage offered by
the PBGC.
It would be great if we could get Congress to compel this by force of
law, but even if they do not act this same goal can be accomplished
through labor negotiations. We managed to obtain just such a clause in
our most recent contract negotiations at UPS and placed our defined
benefit assets into the same plan as our executives. Our aim was to
align our interest with those of upper management. To their credit our
management showed honorable intentions by agreeing to this.
In the future we will see a greater reliance on defined contribution
plans than we have in the past to fund pilot pensions. Because of the
limitations and inadequacies of these plans defined benefit plans will
make a comeback either in their traditional form or in the form of cash
balance plans as newer carriers and legacy carriers which have lost
their DB plans rebuild their retirement systems. It would be imprudent
to rely on DB plans to the extent that we have in the past.
The DB plans will be more carefully chosen to not exceed the PBGC
limits by any great amount, and innovative solutions such as the
commingling of executive pensions are sure to be a topic of discussion
in future labor negotiations throughout our industry.
In the future I would expect to see most unions try to establish a set
of retirement plans that uses a combination of defined contribution and
defined benefit plans to meets the retirement needs of their members.
By using a combination of defined benefit and defined contribution
plans we minimize the risks and limitations associated with each
particular type of plan. We don't have all our eggs in one basket.
In the meantime fully funding our personal savings by making the
maximum contributions to our 401K's or IRA's seems prudent because we
all can't expect 20% to 25% a year on our investment returns. Though
I'm sure if we talk about his around the crewroom we will find a few
who do.
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