The Benefits Trap

Old-line companies have pledged a trillion dollars to retirees. Now they're struggling to compete with new rivals, and many can't pay the bill.

June 28 was the day hope ran out for United Airlines' 35,000 retirees. That was the day the government announced it would not guarantee the bankrupt airline's loans -- virtually assuring that if UAL Corp., (UALAQ ) the airline's parent, is to remain in business it will have to chop away at expensive pension and retiree medical benefits. The numbers are daunting. UAL owes $598 million in pension payments between now and Oct. 15, and a total of $4.1 billion by the end of 2008, plus an additional $1 billion for retiree health-care benefits, obligations the ailing airline can't begin to meet. And if United finds a way to get out of its promises, competitors American Airlines (AMR ), Delta Air Lines (DAL ), and Northwest Airlines (NWAC ) are sure to try to as well.

UAL workers are about to find out what other airline employees already know: The cost of broken retirement promises can be steep. Captain Tim Baker, a 19-year veteran of US Airways Inc. (UAIR ), was one of several union representatives sorting through that airline's complicated bankruptcy negotiations in March, 2003. Of the airline's many crises, the biggest was the pilots' pension plan, a sinkhole of unfunded liabilities. Baker reluctantly agreed to back US Airways' proposal to dump the pension plan on the Pension Benefit Guaranty Corp. (PBGC), the government agency that is the insurer of last resort for hopelessly broken plans. It's a move that practically guarantees that retirees will receive less than they were promised, in some cases less than 50 cents on the dollar. But of a raft of bad options, it seemed the only one that could keep the company afloat. "It was the pension underfunding and its future requirements that were going to put in jeopardy the airline's ability to get out of bankruptcy," says Baker. "At some point you have to look around and say that is all there is."

Baker has paid dearly for that decision. He was voted out of his union position by angry fellow pilots and instead of the six-figure annual pension he was promised, when he retires in 15 years he'll get just $28,585 a year from the PBGC, plus whatever he can save in his 401(k).

Stories like Baker's are becoming dreadfully common as employers faced with mounting retiree costs look to get out from under. It's not just troubled industries like airlines that are abandoning their role as retirement sponsors to America's workers, either. The escalating cost of retirement plans is a critical issue at a range of long-established companies from Boeing (BA ) to Ford Motor (F ) to IBM (IBM ), many of which compete against younger companies with little or nothing in retiree costs.

SHIFTING THE RISK

As employers abandon ever-more-costly traditional retirement plans, the burden is falling on individuals and taxpayers

Why are retirees being left out in the cold? An unsavory brew of factors have come together to put stress on the retirement system like never before. First, there's the simple fact that Americans are living longer in retirement, and that costs more. Next come internal corporate issues, including soaring health-care costs and long-term underfunding of pension promises. Perhaps most important, in the global economy, long-established U.S. companies are competing against younger rivals here and abroad that pay little or nothing toward their workers' retirement, giving the older companies a huge incentive to dump their plans. "The house isn't burning now, but we will have a crisis soon if some of these issues aren't fixed," says Steven A. Kandarian, who ended a two-year stint as the executive director of the PBGC in February. Kandarian is not optimistic about how that crisis might play out, either. "By that time it will be too late to save the system. Then you just play triage."

As industry after industry and company after company strive to limit -- or eliminate -- their so-called legacy costs, a historic shift is taking place. No one voted on it and Congress never debated the issue, but with little fanfare we have entered into a vast reorganization of our retirement system, from employer funded to employee and government funded, a sort of stealth nationalization of retirement. As the burden moves from companies to individuals -- who have traditionally been notoriously poor planners -- it becomes near certain that in the end, a bigger portion will fall on the shoulders of taxpayers. "Where the vacuum develops, the government is forced to step in," says Sylvester J. Schieber, a vice-president at benefit-consulting firm Watson Wyatt Worldwide (WW ). "If we think we can walk away from these obligations scot-free, that's just a dream."

EVIDENCE OF THE SHIFT is everywhere. Traditional pensions -- so-called "defined-benefit" plans -- and retiree health insurance were once all but universal at large companies. Today experts can think of no major company that has instituted guaranteed pensions in the past decade. None of the companies that have become household names in recent times have them: not Microsoft (MSFT ), not Wal-Mart Stores (WMT ), not Southwest Airlines (LUV ). In 1999, IBM, which has old-style benefits and contributed almost $4 billion to shore up its pension plans in 2002, did a study of its competitors and found 75% did not offer a pension plan and fewer still paid for retiree health care.

Instead, companies are much more likely to offer defined-contribution plans, such as 401(k)s, to which they contribute a set amount. In 1977, there were 14.6 million people with defined-contribution benefits; today there are an estimated 62.5 million. Part of their appeal has been that a more mobile workforce can take their benefits with them as they hop from job to job. But just as important, they cost less for employers. Donald E. Fuerst, a retirement actuary at Mercer Human Resource Consulting LLC, notes that while even a well-matched 401(k) often costs no more than 3% of payroll, a typical defined-benefit plan can cost 5% to 6% of payroll.

Despite the stampede to defined-contribution plans, there are still 44 million Americans covered by old-fashioned pensions that promise a set payout at retirement. All told, they're owed more than $1 trillion by 30,000 different companies. Many of those employers have also promised tens of billions of dollars more in health-care coverage for retirees. Even transferring a small part of the burden to individuals or the government can have a profound impact on the corporate bottom line. The decision by Congress to have Medicare cover the cost of prescription drugs, for example, will lighten corporate retiree health-care obligations by billions of dollars. Equipment maker Deere & Co. (DE ) estimates that the move will shave $300 million to $400 million off its future health-care liabilities starting this year.

The U.S. Treasury, on the other hand, pays and pays dearly. That drug benefit, which takes effect in 2006, is expected to cost the government the equivalent of 1% of gross domestic product by 2010, and other potentially big taxpayer costs are looming, too. In mid-April, over the objections of the PBGC, Congress granted a two-year reprieve from catch-up pension contributions for two of the most troubled industries: airlines and steel. Congress also lowered the interest rate all companies use to calculate long-term obligations, lowering pension liabilities. While these moves lighten the corporate burden, they increase the chances taxpayers will have to step in. "The less funding required, the more risk that's shifting to the government," says Peter R. Orszag, a pension expert and senior fellow in economic studies at the Brookings Institution. "The question is: How comfortable are we with the risk of failure?"

Company-sponsored health care, which generally covers retirees not yet eligible for Medicare and supplements what Medicare will pay, is likely to disappear even faster than company pensions. Subject to fewer federal regulations, those benefits are easier to rescind and companies are fast doing so. It's much harder to renege on pension promises. So instead, many profitable companies are simply freezing plans and denying the benefits to new employees. Last fall, Aon Consulting (AON ) found that 150 of the 1,000 companies they surveyed had frozen their pension plans in the previous two years, a dramatic increase from earlier years. Another 60 companies said they were actively considering following suit.

STRESS ON A FRAGILE SYSTEM

The government bailout fund is $9.7 billion in the red, and Social Security and personal savings are hardly going to be enough

The cost of honoring PBGC's commitments could be higher than anyone is expecting. The government bailout fund has relied on having enough healthy companies to pony up premiums to cover plans that fail. But in a scenario of rising plan terminations, healthy companies with strong plans still in the PBGC system would be asked to pay more. For corporations already fretting that pensions have become a competitive liability and a turnoff to investors, this could be the tipping point. Faced with higher insurance costs, they could opt out, rapidly accelerating the system's decline as the remaining healthy participants become overwhelmed by the needy. In the end, the problem would land with Congress, which could be forced to undertake a savings-and-loan-type bailout. It's almost too painful to think about, and so no one does. But when the bill comes due, it will almost certainly be addressed to taxpayers.

Most worrisome is the record number of pension plans in danger of going under. According to the PBGC, as of September, 2003, there was at least $86 billion in pension obligations promised by companies deemed financially weak. That's up from $35 billion the year before. And it's on top of a record number of companies that managed to dump their troubled pension plans on the PBGC last year: 152. In 2003, a record 206,000 people became PBGC pensioners, including 95,000 from its biggest takeover ever, Bethlehem Steel Corp.

Even for healthy companies, pensions have become a serious drag. The companies of the Standard & Poor's 500-stock index, for example, continue to run an aggregate pension deficit of $149 billion, according to David Bianco, an accounting analyst at UBS (UBS ). That's despite a strong stock market in 2003, which pushed up pension plan assets, and despite the billions companies contributed, including $18.5 billion from General Motors Corp. (GM ) alone. If conditions don't change, Bianco figures the S&P 500 companies will end the year $192 billion in the hole.

WHAT TODAY MIGHT be seen as an isolated problem for a limited number of companies promises to bloom into big trouble for us all. By conventional math, the PBGC is already insolvent: As of September, 2003, it had $46.5 billion of liabilities and only $35 billion of assets, a deficit of $11.5 billion that had close to tripled in one year. The agency paid 2003 benefits of $2.5 billion, but only took in $1 billion of premium income from companies with defined-benefit plans. (The PBGC says the deficit had dropped to $9.7 billion as of March, but can't give further details.) The PBGC is not directly funded by the taxpayer, but it is backed by the U.S. government, which would likely bail it out in a crisis.

The fragility of that system only increases the stress on other sources of retirement income and insurance: Social Security, Medicare, and personal savings. Social Security has its own $11.9 trillion deficit. And the still-recent history of personal savings vehicles like 401(k)s shows that people generally save too little, pay too much in fees, and fail to adequately diversify their risk. Olivia S. Mitchell, executive director of the Wharton School's Pension Research Council, is among the many who think one result is that we will all have to work longer than we thought. "It used to be thought Social Security was the safe leg of the retirement stool, but that's not safe either," says Mitchell.

Demographic trends will only make matters worse. As recently as 1985 there were three U.S. workers for every retired person. Now it's close to even. And we're still six years away from 2010, when the first of the baby boomers will hit 65. Not only are more people retiring, but they're living longer once they get there. Today 17% of the U.S. population is age 60 or older. According to Census Dept. data, that figure will rise to 26% by 2050, when college graduates entering the workforce today can finally begin to think about retiring. It's the complete reversal of the years after World War II, when companies first began offering pension plans in great numbers. In those days the workforce was young and retirees were only a sliver of the population. It was easy to make promises.

The world has changed dramatically since then. In the '40s and '50s, if a company offered retirement benefits, its competitors probably did too. Pattern bargaining by unions held entire industries to the same standard. But companies that once could rely on geographic boundaries and market dominance to minimize the threat of upstarts and outsiders are now struggling to keep up in a global marketplace full of new competitors. Companies like IBM, Verizon Communications (VZ ), and even General Motors today must contend with rivals who don't bear the cost of old-style benefits. For every lumbering US Airways there's an agile Southwest or Jet Blue Airways Corp. (JBLU ), newer rivals with cheaper benefits. For every GM, there's a Toyota Motor Corp., with a leaner and younger U.S. workforce.

Nowhere are pension obligations a greater competitive millstone than in Detroit. The U.S. carmakers today have some of the biggest pension obligations and pool of retirees anywhere. By contrast, their Japanese competition only started U.S. manufacturing in the late 1980s, and have far lower costs. General Motors has 514,120 participants in its hourly-rate employee pension plan, all but 142,617 of whom are retired. Pension and health-care costs for those retirees added up to about $6.2 billion in 2003, or roughly $1,784 per vehicle according to Morgan Stanley (MWD ). Compare that to Toyota's U.S. (TM ) plan, which had only 9,557 participants, just two of whom were retired as of Toyota's latest Internal Revenue Service filing covering 2001. Toyota's pension cost is estimated at something less than $200 per vehicle.

The impact on profits is dramatic. Excluding gains from its finance arm, GM earned $144 per vehicle in the U.S. in 2003. GM's margins are now 0.5%, among the worst in the industry. But without the burden of pension and retiree health-care costs, the auto makers' global margins would be 5.5%, according to Morgan Stanley. That's not great, but a lot closer to Asian carmakers like Honda Motor Corp., which earns 7.5% on its global sales.

GOODBYE, RETIREE HEALTH CARE

Companies are racing to cut or drop retiree medical benefits to give a quick boost to their bottom lines

Retiree health-care coverage, which is easier to eliminate than pensions, is disappearing even faster. Unlike pensions, which are accrued and funded over time, retiree health care is paid for out of current cash accounts, so any cuts immediately bolster the bottom line. Estimates are that as many as half of the companies offering retiree health care 10 years ago have now dropped the benefit entirely. Many of those that have not yet slammed the door are requiring their former workers to bear more of the cost. Some 22% of the retirees who still get such benefits are now required to pay the insurance premiums themselves, according to a study by Hewitt Associates Inc. (HEW ). Some 20% of employers told Hewitt that they might make retirees pay within the next three years. This hits hardest those who retire before 65 and are not yet eligible for Medicare. But even older retirees suffer when they lose supplemental health benefits like prescription coverage.

IT'S NOT JUST struggling companies, either. IBM, which is already fighting with retirees in court over changes made to its pension plan in the 1990s, is now getting an earful from angry retirees about health-care costs. In 1999, IBM capped how much retiree health care it would pay per year at $7,500 of each employee's annual medical-insurance costs. Although IBM is certainly in no financial distress -- the company earned $7.6 billion on $89 billion in sales last year -- Big Blue says its medical costs have been rising faster than revenue. Last year the company says it spent $335 million on retiree health care.

This year, for the first time, many IBM retirees are beginning to hit the $7,500 limit. Sandy Anderson, who worked as a manager at IBM's semiconductor business for 32 years, and today is the acting president of a group of 2,000 retirees called Benefits Restoration Inc., saw his own insurance bill triple this year. He suspects that the company is trying to make the perk so expensive that retirees drop it, a cumulative savings calculated by the group at $100,000 per dropout.

But more than that, Anderson is angry that as a manager, IBM encouraged him to talk to his staff about retirement benefits as part of their overall compensation. The job market was tight, and IBM's message was our salaries aren't the highest, but we will take care of you when you stop working, he says. Now he feels the company is reneging. "I feel I've misled a lot of people, that I've lied to people," says Anderson. "It does not sit well with me at all." IBM says its opt-out levels are low and that it often sees retirees return to the plan after opting out for a period of time. The company also argues that it has not changed its approach to retiree medical benefits for more than a decade and that the rising cost of health care is the real issue.

Even with the reductions, Anderson and his generation of retirees are better off than many. In 2003 the giant computer maker said it would pay nothing toward health insurance for future hires when they retire.

THE PERFECT PENSION STORM

Three years of stock market declines plus record-low interest rates have left pension funds woefully underfunded

One reason companies have hit the accelerator on dumping their benefits is because of sharp price increases. Retirement plans have become radically more expensive in the past two years alone. Due to smoothing mechanisms built into pension accounting, their investments are still suffering from the equity market declines of 2000, 2001, and 2002. That has put a big dent in the value of their stock holdings, generally 60% or more of their total assets. At the same time, interest rates, which are used to calculate the size of a company's liability, have remained stubbornly low, implying a bigger pension liability. Although the recent legislation eases the problem somewhat, it doesn't nearly close the gap between what these funds owe and what they have in assets.

Combined with the rise in retirees, those market conditions have led to two years of record underfunding in company-sponsored plans. A recent study by analysts at CreditSights Ltd. found that 85% of the defined-benefit plans in the S&P 500 don't have enough assets to cover their pension obligations. Together the underfunding equals 15% of their 2003 cash flow. As a result, companies will have to put billions of dollars of cash into these plans this year to help close the gap.

It's a drastic turnaround from the late 1990s when these plans had more than enough money. In 1999, the average S&P 500 pension was overfunded by $726 million, according to CreditSights. Four years later, at the end of 2003, it was $463 million underfunded, a swing of almost $1.2 billion. A steady rise in interest rates and a strong stock market could help to solve that underfunding, but experts worry that the whipsaw effect of the past few years and the billions companies have been forced to contribute has heightened executive discomfort with the volatility of pensions. According to Credit Suisse First Boston (CSR ) analyst David Zion, the companies in the S&P 500 have contributed $88 billion to their pension plans over the past two years. They're likely to have to add another $31 billion over the next two years. Despite an $18.5 billion infusion into its pension plan in 2003, it will take years before General Motors, for example, has fully funded plans. "These things have a fairly long tail," says GM Chairman and CEO G. Richard Wagoner Jr.

Companies didn't make it any easier on themselves by contributing as little as possible to their pensions in the booming 1990s. As recently as 2001, half of the large pensions monitored by actuaries at Milliman USA were generating pension income, contributing an aggregate $12.5 billion boost to their parent companies' reported earnings. Companies with overfunded pension plans were often able to fund retiree health care with pension overage. Many companies contributed little or nothing to their pension plans as the bull market drove up assets more than enough. Former PBGC chief Kandarian notes that adjusting for inflation, in the early 1980s plan sponsors were putting $63 billion per year into their plans. By the last half of the 1990s that had dropped to $26 billion, and companies had become used to getting expensive benefits on the cheap.

WHEN THEY DID contribute, it was often not with cash but with stock, real estate, and other less liquid "alternative" investments. With pension promises basically free, companies were also offering pension increases in lieu of salary raises, increasing their obligations. From 1980 to 2000, the size of the promises made grew 2.3 times, Kandarian says.

Among those making the most extravagant retirement pledges were the steel mills, and it was in their plans that the industry's weakness was most dramatically realized. In a massive wave of bankruptcies, the steelmakers have shifted $7.5 billion of their obligations to the PBGC in the past 3 years.

But in that disaster some have found an opportunity to arbitrage the difference between the old retirement model and the new. International Steel Group Inc. (ISG ) has in the past two years grown into the largest steelmaker in the country by acquiring the mills of old steel companies, including Bethlehem Steel, LTV, and Acme Metals out of bankruptcy, once they've been freed of pension and health-care promises. These companies had been pummeled by cheaper international competition as well as lower-cost U.S. mini-mills, and as they shrank to cut costs, their retiree bases mushroomed to many times the size of the active workforce. Faced with the possibility that they would lose all the remaining jobs left at these companies, the United Steelworkers union was eventually willing to compromise.

RISK ARBITRAGE

A company free of its retiree promises can become a tougher competitor -- though former workers suffer

Free of those pension promises, ISG chairman Wilbur L. Ross Jr. enjoyed the big run-up in steel prices on a much cheaper cost base than many of his competitors. ISG's predecessor companies shed $12 billion of legacy health-care costs and another $9 billion of pension obligations. The company today claims to be competitive with both international steelmakers and efficient U.S.-based mini-mills. ISG's defined-contribution cost for employees was $45 million in 2003. Its very modest retiree health-care benefits cost $4.3 million. By contrast, Bethlehem Steel alone was paying out $500 million a year in pension benefits. Today, U.S. Steel Corp. (X ) has moved to an ISG-style defined-contribution pension plan, but only for future retirees. It still owes $8 billion to existing pensioners.

It's a bit of retiree-cost arbitrage that won't last forever. But before it's over, Ross predicts other industries will follow this harsh path to competitiveness. Those most at risk: textile makers, airlines, tire and rubber companies, auto-parts suppliers and, potentially, he says, the auto makers. "There is a huge unfunded liability that's building up because of the defined-benefit system," says Ross. "If nothing changes, the stone they [PBGC] have to roll up the hill will just get heavier."

Workers bear the brunt of it. Bill Luoma, head of the Mahoning Valley Steelworkers Retirees Council, which counts bankrupt LTV retirees among its members, says that with their health insurance gone, many have stopped visiting doctors other than for emergencies. For companies struggling to compete in the global economy, carrying those burdens themselves is like strapping on a 200-pound weight to run a 40-yard dash. But to shed them is to leave decades of workers devastated. In the end, someone will have to pay. The only question is who.

Corrections and Clarifications "The benefits trap" (Cover Story, July 19) should have said that it was a Congressional increase, not decrease, in the interest rate used to calculate pension liabilities that caused those liabilities to decline. It also should have said that Bethlehem Steel was located in Steelton, Pa. (not Stilton). And the table supplied by UBS Investment Research ("Graphic: Pension Woes"), was based on faulty data. Two companies, AES and Allegheny Technologies, should not have been on the list. The 2003 pension deficit as a percentage of market capitalization for Delta Airlines should have been 387.9%, for Ford Motor 39.9%, and for Hercules 27.3%.

By Nanette Byrnes with David Welch in Detroit

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