General Electric's nearly $30 billion pension deficit, which is the largest of any major U.S. corporation, has earned plenty of headlines in the past year. However, as a percentage of revenue or market cap, Delta Air Lines (NYSE:DAL) has faced an even bigger pension funding gap in recent years. As of the end of 2016, Delta had the second-worst funding ratio in the S&P 500 and a $10.6 billion pension deficit. It also had a $2.6 billion deficit in its other postretirement plans.
Delta reduced its pension deficit significantly in 2017, though. Furthermore, rising interest rates could help it make additional progress in addressing its pension underfunding over the next two to three years.
Pension assets soar
About a year ago, Delta Air Lines decided to take advantage of the low-interest-rate environment by issuing debt to accelerate its pension funding. This allowed it to make a big dent in its pension deficit during 2017.
In total, Delta Air Lines contributed about $3.2 billion of cash to its pension plan in early 2017. It also provided $350 million of Delta stock, bringing total funding for the year to $3.56 billion. Meanwhile, the company contributed more than $250 million to its other postretirement plans, which provide things like healthcare and disability coverage.
Stellar investment returns gave Delta an extra boost last year. The return on pension-plan assets was nearly $2 billion. That represents a roughly 15% gain based on the weighted average amount of plan assets during 2017. The other postretirement plans also achieved double-digit investment gains. The net result was that total assets across all of the plans increased by more than $4.5 billion, despite benefit payments of $1.4 billion.
On the other side of the ledger, Delta's pension and postretirement liability increased by nearly $1 billion in 2017. This was driven by a 0.51 percentage-point reduction in the discount rate used to calculate the liabilities. Even so, the funding deficit improved by more than $3.5 billion.
Reducing costs -- by playing accounting games
Coming into 2018, holding non-fuel unit-cost growth to a minimum was the top priority for Delta Air Lines. The huge increase in Delta's pension-plan assets will help in a big way, due to the somewhat bizarre rules of pension accounting.
For accounting purposes, the expected return on the plan's assets acts as a credit against pension expense. The higher the level of plan assets -- or the higher the level of expected returns -- the bigger this credit. In some cases, this can more than offset the other components of pension expense, leading to companies reporting pension income.
Delta Air Lines has historically assumed extremely strong returns of nearly 9% for its pension assets. While its actual returns surpassed that target last year, it routinely fell short in each of the previous three years, including an outright loss in 2015. Most experts would agree that Delta's expected return on plan assets is unrealistically high.
Nevertheless, Delta's expected return on plan assets stands for now. As a result, the big increase in its pension assets in early 2017 reduced its total pension/postretirement plan costs to $137 million last year from $390 million a year earlier. In 2018, that could conceivably go to zero, even though the company is still underfunded by $9.6 billion.
The bottom line is that lower pension expense is helping Delta reduce its unit-cost growth -- but this may reflect Delta taking advantage of the intricacies of pension accounting more than any improvement in its underlying cost structure.
Rising rates could help close Delta's funding gap
Despite the big improvement in its pension deficit last year, Delta still has plenty of work to do to reach fully funded status. Fortunately, rising interest rates should do some of that work.
As noted above, in 2017, Delta Air Lines reduced the discount rate used to calculate its pension obligations, adding about $1 billion to its pension liability. However, interest rates have risen significantly since the beginning of 2018. With inflation starting to accelerate, market watchers are increasingly expecting a sustained increase in interest rates going forward.
A 0.5 percentage-point increase in the discount rate would reduce Delta's pension liability by about $1.2 billion, according to the company. If long-term interest rates increase by that amount annually for the next three years, it would knock about $3.5 billion off Delta's pension liability. Delta is contributing about $500 million a year to its pension plan, which could be 90% or more funded by the end of 2020, depending on its actual investment returns.
The steep decline in Delta Air Lines' pension/postretirement expense since 2016 overstates the improvement in its funding position. Nevertheless, it's clear that Delta has made significant progress toward putting its once-ailing pension plan on a firm footing.