Last year, Delta Air Lines (NYSE:DAL) reached a tentative agreement on a new four-year contract with its pilot union, nearly seven months before its existing contract was scheduled to become amendable. (Airline labor contracts never formally expire.) It seemed like Delta was well-positioned to continue its history of friendly labor relations.

However, Delta's pilots rejected the tentative agreement by a 65%-35% margin. A key sticking point for many pilots was that while the contract provided raises of more than 21% over three years, it would have reduced their profit-sharing payouts.

Delta is having a hard time agreeing with its pilots on a new contract. Photo: The Motley Fool

Delta's management and its pilot union seem to be as far as ever from reaching a deal. Last week, the two sides both filed for mediation, as was required under the previous contract. Now, federal mediators will have to try to coax both sides into making reasonable compromises.

Pilot pay is going up
The dispute between Delta and its pilots comes in the midst of a growing U.S. pilot shortage. Airlines face a wave of mandatory pilot retirements in the coming years, while federal safety regulations have made it extremely expensive for aspiring pilots to become certified to fly passenger jets. The supply demand imbalance has been driving pilot wages steadily higher.

In early 2015, American Airlines (NASDAQ:AAL) pilots approved a new contract including immediate pay raises averaging 23%, followed by 3% annual raises for five years. American Airlines base pilot wages are now about 8%-15% higher than at Delta.

Earlier this year, pilots at United Continental (NASDAQ:UAL) agreed to a contract extension that raised their base pay to the top of the industry. For a few aircraft types, base pay is roughly comparable between American and United, while United Airlines pilots are paid up to 5% more for some aircraft types.

Pilots at United now have the best base pay among passenger carriers. Photo: The Motley Fool

Among the three legacy carriers, Delta pilots now have the lowest base pay. However, the American Airlines pilot deal didn't include any profit sharing, although the company recently announced plans to distribute 5% of its pre-tax profit as profit sharing going forward. Meanwhile, United Continental has a fairly generous profit-sharing plan, but due to its lower profitability, it paid out less than half as much as Delta in profit sharing for 2015.

Negotiations get bogged down
After pilots rejected Delta's contract offer last summer, the union made a counter-proposal in December. While the union describes its proposal as "market-based," it calls for an immediate 22% pay increase, followed by two 7% annual raises.

That would lead to a total base pay increase of 39.7% by 2018. It's not clear that the proposal included any profit-sharing reduction to offset the base wage increase. Not surprisingly, this offer went nowhere with Delta's management.

To justify their proposal, pilot union leaders at Delta have noted that the new contract at United Continental puts United pilots 16% ahead of Delta pilots in terms of base compensation. Even so, their proposal would leapfrog Delta pilots ahead of United pilots by 6% immediately, and put them nearly 15% ahead by 2018.

Both sides need to compromise
Delta Air Lines has reliably been near the top of the airline industry in profitability in recent years. It is reasonable for employees to expect to get paid somewhat more than their peers at less successful airlines.

However, the annual cost of the Delta pilots' contract proposal would be $750 million by 2018, according to Airways News. Furthermore, Delta's other employees -- who earn a fraction of what a pilot makes -- would be just as deserving of raises. Handing out 40% raises across the board would likely push the annual cost past $2 billion.

Delta could afford that today, but if oil prices recover in the next few years, it could take a multi-billion dollar bite out of the company's profitability. So while Delta needs to up its original offer, it wouldn't make sense for it to meet the union's demands.

Delta's pilot union may be in for a shock when the federal mediation process gets going. Given that Delta's original proposal was already more or less in-line with the other industry leaders in pay -- whereas the union appears to want a 15% premium relative to United Airlines pilots -- there's a good chance the mediator will tell the union that it is being unrealistic.

Furthermore, under the Railway Labor Act, airline employees aren't allowed to strike unless they are "released" by the mediator." That means the pilots have essentially no bargaining leverage.

The mediator will probably also ask for concessions from Delta so that pilots have something to show for their trouble. But if the pilots want to get their (well-deserved) raises, they will have to drop their asking price significantly.

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