Classic Moral Hazard

According to the WSJ($), you and I are going to take on the pension obligations of UAL:

A bankruptcy judge approved a
proposal from United Airlines parent UAL Corp. to transfer four
underfunded employee pension plans to the federal government, paving
the way for the largest pension default in U.S. corporate history.

The plans, which have a shortfall of $9.8 billion,
cover more than 120,000 United workers and retirees. United, the
nation's second-largest carrier in terms of traffic, wants to transfer
them to the federal Pension Benefit Guaranty Corp., or PBGC, which
would add to the already heavy strain on the agency from a spate of
pension defaults in recent years. Since accounting for United's
obligations last year, in anticipation it would assume them, the agency
has taken on obligations exceeding its assets by $23.3 billion  [ed note- the agency takes in only about $1 billion a year in premiums, so $23.3 billion in the hole is a very big number]....

The court's decision could have wide
repercussions in the airline industry, which is struggling with high
fuel costs, intense fare competition and overcapacity. Sidestepping its
pension liabilities will help UAL attract additional funding, while
giving it a huge cost advantage over many of its rivals, which are
saddled with underfunded defined-benefit retirement plans of their own.
That will put further pressure on those airlines to slash their costs
or in some cases seek bankruptcy protection in hopes of terminating
their own pension plans.

It is difficult for me to even start on how much this pisses me off.  These pensions are real obligations that UAL took on, and represent value provided in exchange for work that has already been done.  As outlined below, I am not big on the defined benefit pension model, but that does not change the fact that these companies are defaulting on a solemn obligation.  The temptation I guess is always great when finances get tight to defer obligations that are the farthest in the future, and so pension underfunding is one of the first things to occur.  There is no way management should get a pass for this, and I am flabbergasted that equity holders expect to retain anything out of the bankruptcy when employees have not been fully paid.

This being said, there is plenty of blame to go around, including for the union and the government.  The UAL unions should have been dropping the hammer on the company in the form of strikes or whatever at the first sign of under-funding.  Instead, they were more concerned about jacking up their salaries to the highest levels in the industry, ignoring the reality that airline finances by the late 90's were basically a balloon that if you pushed on it in one place, it popped out in another.  Unions allowed the underfunding to continue in large part lulled by the promise of the PBGC and taxpayers to make the pension funds whole if they continued to be underfunded.  This is the moral hazard that occurs in any kind of financial insurance like this, and the unions apparently were both right and wrong - we taxpayers will take on the obligations but their benefits will also get a haircut.

One of the lessons I thought was learned from the S&L bailouts of the 90's was that you can't provide such financial insurance without a parallel regulatory structure to make sure some kind of minimum fiduciary responsibility exists.  But, not learning a thing, the government has this pension guarantee program in place and exercises virtually no oversight over the funding or management of the insured pensions.

It is astounding to me that a large number of people still support defined benefit plans over defined contribution plans. What I don't honestly understand is why the rank and file still buy into this.  Defined contribution plans are much easier to monitor and audit and keep companies honest.  Once the money is in a vehicle such as a 401K, the money can't be taken away by the company or lost in a bankruptcy (unless the 401K is invested in the company's stock, which any adviser will tell you to never, ever do (see "Enron").  Now, I understand that there can be some tricky migration issues from one system to another, and companies use the transition as an excuse to cut back on their net contributions, but these are workable and negotiable issues .  My guess is that the support for defined benefit plans comes mainly from union leadership, since these plans give
them control of huge amounts of funds and thereby gives them extra
power (see Teamsters for the classic example, or more recently, the situation at Calpers).  I wrote more on this topic here.

The issues here are surprisingly similar to the Social Security debate, as discussed here.  Would you rather have the money in your own account, despite the fact you will then have to bear market risks, or would you rather the money remain in the hands of your company or your Congress.  In entirely parallel situations, money entrusted to UAL management and to Social Security has all been spent, with nothing now left to pay retirees. 

Update:  It just occured to me to ask - why don't frequent flyer mile holders ever have to take a haircut in an airline bankruptcy?  We frequent flyers are creditors too, holding a claim on the company in the form of our miles.  In fact, I would think my claim as a holder of miles is much much worse than other creditors.  For example, why should employees have their pensions cut before I get my miles account cut?  Heck, employees seem to have a much better claim than I do, especially since many of my miles were earned, like everyone else's, as marginally ethical kickbacks directly to me for influencing my employer's spending on air travel.  Despite this, it appears that pensions will be cut, and salaries will be cut, and bondholders will lose value, and stockholders will be diluted, but my miles will all still be good.

Update #2: Assymetrical information has a nice post along the same lines, pointing out an issue with corporate defined benefit pensions that I forgot to mention:  If you are 20 years old with a company, are you really willing to make a bet that your company will even exist in 60 years to pay off your pension?  Not to mention the portability issues, since few people remain with the same company to retirement.  I think I actually have a couple of defined benefit pension plans I am vested in from early in my career - one from Exxon, when I was about to quit to go back to school and was offered, due to poorly structured plan rules, the chance at early retirement instead.  I think I qualify for like $1.23 a month for life from that plan.

More also from Will Collier:

I don't mean to tread on Martini Boy's turf here, but the pensions
crisis among all of these old-line companies illustrates a great no-no
of long-term investing: lack of diversification. In the end, even
though they presumably didn't have much choice in the matter, all those
UAL employees who've been promised a defined-benefit pension are in the
same boat as the Enron and WorldCom employees who voluntarily put all
of their 401(k) money in their own company's stock. They bet the house
on one horse, and by they time old age caught up with the grizzled nag,
there was barely enough left of it to cart off to the glue factory

Kevin Drum also points out that these defined-benefit funds are easy to manipulate, since managers can play with the "expected returns" variable to change the necesary annual contribution. 

  • Scott

    Excellent, Warren.

  • Doug

    This is a good example of why individuals should not rely on corporations *or* government to provide for their retirement. Unfortunately, I imagine the politicians will jump on this story as an example of why we need social security, claiming that "big business" can not be relied upon.

  • http://www.theglitteringeye.com Dave Schuler

    Make no mistake: rent-seeking is the new entrepeneurialism.

    Doug, I'm curious. How do you think people should provide for their retirements? Investing in equities is depending on corporations. That leaves bonds, real estate, or gold. Gold retains value. It does not appreciate. You can buy about the same with an ounce of gold as you could five hundred years ago. Bonds are either corporate or government. Investing in corporate bonds is depending on corporations and investing in government bonds is depending on government. That leaves real estate. Do you think everybody can provide for their retirements by investing in real estate?

  • Doug

    Dave: I, as an individual, can invest in government bonds, corporate bonds, junks bonds, savings accounts, real estate, stocks, whatever I want. I just don't want someone else making those choices for me (translation: taking those choices away from me), which is what happens with Social Security and pensions. Yes, there's risk. There is also risk with pensions, which is why we have PBGC. There is also risk with Social Security in that benefits could be cut or eliminated, although politicians don't like to admit that, they call it a "guaranteed benefit".