Pension deficit an airline merger hurdle

British Airways PLC's estimated £2.7 billion pension deficit could still become a hurdle in the merger talks with Iberia Líneas Aereas de Espana SA, but it probably won't be an insurmountable one.

Consultants and analysts following the talks believe officials with Madrid-based Iberia will ultimately put the firm's survival ahead of concerns about future BA pension liabilities, despite the potential risk the massive deficit might have on the combined company's balance sheet.

“It still is a difficult issue conceptually in as far as Iberia is concerned,” said Nicholas Cunningham, analyst at Evolution Securities Ltd. in London, who covers the airline industry. Company officials realize that the value of the deficit “will affect the joint company's share price,” he said.

Iberia needs to complete the deal for its own economic sake. Iberia is “too small to remain independent,” Mr. Cunningham added, “and if they look around at the potential partners that can bring scale, BA is just about the only game in town.”

As of Sept. 30, London-based BA had about £12.2 ($20.2 billion) in pension assets globally.

Its pension deficit is valued around £2.7 billion while the company's market capitalization is about £2.4 billion, leading one competitor to dub BA as “a pension deficit with wings.” Iberia's pension obligations fall under Spain's public pension system, which is funded by contributions from employers and employees nationwide; therefore, the airline has no pension liabilities on its balance sheet.

On Nov. 12, BA and Iberia announced plans to merge. If completed, the transaction would create a new company called TopCo, with BA shareholders likely to take a 55% stake.

According to a clause in the agreement, “Iberia will be entitled to terminate the merger agreement if the outcome of the discussion between British Airways and its pension trustees is not, in Iberia's reasonable opinion, satisfactory because it is materially detrimental to the economic premises of the proposed merger.”

Iberia has appointed Mercer LLC, London, to advise on the pension issues. BA officials are prepared to assuage Iberia shareholders, according to consultants who spoke on the condition that they not be identified. The BA proposals might include:

• TopCo “will not provide any guarantee or use any cash or credit facilities to fund the BA pension schemes,” according to the announced agreement. The consultants said one way of accomplishing that goal is to “ring-fence,” or separate, the pension liabilities from the combined company's liabilities for a period of five years.

• BA officials might also propose extending its annual contributions of about £280 million for longer than the 10-year period initially agreed with U.K. regulators in 2007 to improve pension funding levels.

• Another option, albeit more politically challenging, is to freeze the BA fund, according to one consultant. “Any scheme that is closed to new members eventually will be closed to new accruals ... and BA is no exception,” the consultant said. BA closed its two defined benefit plans — the £7.3 New Airways Pension Scheme and the £6.2 Airways Pension Scheme, both of London — to new members in 2003.

BA executives have until June to negotiate with trustees on a plan to reduce the funding deficit, and both companies have until November 2010 to complete the merger deal. However, BA officials have said they are aiming to complete the transaction earlier.

In February 2007, BA announced plans to narrow a pension deficit gap valued then at £2.1 billion. The company reduced benefits, raised the pensionable retirement age and injected a one-time cash contribution of £800 million. It was then that BA also agreed to the £280 million annual contribution for 10 years.

“Looking at one of the highlights of the year, I am particularly pleased that we tackled the £2.1 billion deficit,” BA Chairman Martin Broughton wrote in the company's 2007 annual report.

However pension executives did not reduce the New Airways plan's reliance on the equity premium for returns, and the subsequent plunge in global markets proved detrimental. About 62.5% of the NAPS plan is invested in equities compared with about 15% of the older Airways plan as of March 31.

Bonds accounted for 27.5% of NAPS' allocation and 79% of APS' assets.

Accordingly, the NAPS deficit was £2.7 billion as of Sept. 30 and the APS plan recorded a surplus of £27 million at the same date, according to company data. Peter Russell, spokesman for BA trustees, declined to comment about the negotiations relating to the merger.

There are three ways trustees might look to reduce pension deficits: extend the time scale over which contributions from the sponsor are collected; seek larger contributions, which can include cash or contingent assets; and focus on investment strategies to outperform liabilities, consultants said.

“Trustees will want as much upfront funding as possible, but there's a danger that if they ask for too much too quickly, they might put the company in danger” of being able to effectively compete in a difficult market, said Ian Maybury, managing director, senior actuary and co-head of asset-liability management and investment strategy at Redington Partners LLP based in London.

“It's a balancing act,” Mr. Maybury added.

Ros Altmann, a pension policy expert who has advised the U.K. government and various pension funds, added that government regulators, company officials and pension trustees will ultimately want to see the transaction completed. “BA's pension scheme is too big to fail,” she said.

The potential merger with Iberia is “good news for the pension scheme in two ways,” said John Ralfe, an independent pension consultant based in London. “The bigger (combined) airline should be stronger with commercial synergies. Secondly, whatever ring-fencing is initially envisaged, there's no question that the pension scheme will eventually have access to Iberia assets. ... So the pension trustees won't want to block the deal.”

Meanwhile, the possible deal between British Air and Iberia isn't the only one in the airline industry to be weighed down by pension deficits. Japan Airlines Corp., Tokyo, is struggling under debt valued at about $9.4 billion as of Sept. 30. A major stumbling block to the airline's rescue is a ¥330 billion ($3.7 billion) pension shortfall.

At JAL, Asia's largest airline, officials are negotiating with employees to slash pension benefits by an average of about 40% in order to reduce the shortfall. CEO Haruka Nishimatsu met with employees on Nov. 23 and was scheduled to meet again on Nov. 26 “to seek the support and understanding of the retirees” to implement pension cuts, JAL spokeswoman Sze Hunn Yap said in an e-mail response to questions. Company officials are aiming to finalize the changes by the end of January.

En route to its fourth annual loss in five years, JAL earlier this month filed an application for government loans to keep the airline afloat. As part of the conditions to obtain the funds, JAL was required to cut pension costs. Any public aid cannot be used to sustain the JAL Group Pension Fund, which had about ¥408 billion in assets as of March 31, according to government documents.

U.S. competitors including Delta Air Lines Inc., Atlanta, are considering buying a stake in the ailing airline. AMR Corp., the Fort Worth, Texas-based parent company of American Airlines, is also pondering a stake in JAL in a joint investment with private equity firm TPG, Fort Worth.

A spokeswoman for TPG and a spokesman for AMR declined to comment. Delta officials did not return calls seeking comments by press time.