How Wall Street Wrecked United's Pension

["Miklos A. Vasarhelyi" <miklosv@andromeda.rutgers.edu>]

July 31, 2005

How Wall Street Wrecked United's Pension

By

MARY WILLIAMS WALSH

HAD anyone listened to Doug Wilsman, tens of thousands of United Airlines
employees would not be facing big cuts in their pensions. And the federal
agency that guarantees pensions might not be struggling with its biggest
losses ever.

So who is Doug Wilsman? He is a retired pilot and a former fiduciary of
United's pension plan for pilots, and in 1987 he discovered that the
company had abandoned its older, tried-and-true approach of investing
retirees' money in bonds timed to pay when the pensions came due.
Instead, it had bought into the promises of Wall Street that it could put
less money into the plan - and take out more later - if it just put most
of the assets into the stock market.

Mr. Wilsman was skeptical of such promises, and soon after learning of
the change in strategy, he filed a grievance with his union, the Air Line
Pilots Association. "Hey, you guys are really building yourselves a
trap," he recalled warning them at the time. "Someday, at the
worst possible moment, when the bottom falls out of the stock market, the
plan is going to have to come up with new money, and it's going to be
enough to kill the company."

"Everybody knows stocks are cyclical," Mr. Wilsman said last
week. So is the airline business. All along, he said, he thought it was
almost inevitable that both would one day go south at the same time, with
catastrophic results - which is just what happened this year.

Given Mr. Wilsman's prescience, one might think that experts would be
examining how United's investment strategies contributed to the demise of
its pension funds - and whether similar scrutiny elsewhere could prevent
more pension plans from crashing.

Not a chance. Congress, regulators, lobbyists and the news media are all
scrambling to find out what has gone wrong with the pension system.
Hearings have been convened in the wake of United's default, chief
executives examined under oath, bills introduced in Congress, numbers
crunched. But virtually everyone is looking at the rules covering how
much money a company puts into a pension plan every year - not at what
happens to the money after that.

While the money managers and other pension professionals who ran United's
pension plan walked away from the wreck unscathed - indeed, they
collected about $125 million in fees over the last five years alone,
records show - the ones who will have to pick up the bill for the
advisers' collective failure will be the airline's 130,000 employees and
pensioners, the federal pension guarantor and probably, someday, the
taxpayers.

The Pension Benefit

Guaranty Corporation has said that since 1974, when the insurance
program was created, United has paid a little less than $100 million in
premiums to insure employees' pensions. Of the $6.8 billion the agency
will pay United's retirees in coming years, all but what United paid in
premiums will be borne by the other companies participating in the
insurance program. 

If those companies ever tire of footing other companies' bills, they may
cancel their pension plans and drop out of the system. At that point, the
taxpayers will have to step in.

United is far from unique. Lifting the lid on how most pension funds are
invested might raise an outcry if the 44 million Americans covered by
company plans knew these things: 

Pension investing is largely unregulated, even though the federal
government effectively covers the investment losses when a
defined-benefit plan fails. At United, this freewheeling approach gave
rise to investments in junk bonds, dot-coms and even what appears to be
an energy venture in Albania.

The Securities and Exchange Commission recently said that more than half
of the consultants who help pension funds invest their money have outside
business relationships that could taint their advice.

It's impossible to get a current list of a company's pension investments.
The most detailed, up-to-date information, on file at the Labor
Department, is at least two years old.

The Labor Department records also show that the money managers,
actuaries, consultants and other professionals who handled United's
pension plan earned about $125 million from 1999 to 2003, paid out of
plan assets. The records are silent on how the individual money managers
performed, nor do they even mention United's main pension consultant, the
Russell Investment Group, or how much it was paid.

OFFICIALS at the Pension Benefit Guaranty Corporation, the federal agency
that takes over pension funds when they fail, are combing through
United's pension documents, trying to ascertain how much the agency owes.
What is clear is that as United's pension obligations soared, its pension
assets fell. By the time the airline turned over its plan to the pension
agency, the shortfall was $10.2 billion.

While the federal agency tries to pinpoint its obligations, apparently no
one in an official capacity is pausing to ask who the plans' outside
investment professionals were, much less how they made their decisions
and how they responded as the airline's fortunes faded.

"It's just a nonstarter," said Richard A. Ippolito, the pension
agency's former chief economist, who is now retired. A few years ago, he
recalled, a director of the federal pension agency appeared before
Congress and suggested that if companies wanted to invest their pension
funds in stocks, they should pay more for their pension insurance
coverage.

"I could politely say that he was vilified," he said.
"They basically accused him of being un-American because he was
asking companies to pay for the privilege of investing in stocks. He just
dropped that idea."

United's actions offer a typical example of how most companies manage
their pension funds. Its portfolio may look aggressive in hindsight -
including high-yield bonds in companies like Adelphia and

Bethlehem Steel that eventually went bankrupt, technology stocks that
evaporated when the bubble burst and an assortment of private
partnerships.

But the general approach was in keeping with what most companies do:
about 60 percent stocks, 30 percent bonds and a mixture of
"alternatives" including real estate and private equity
investments. Local governments often invest their pension funds much more
aggressively.

A spokeswoman for United, Jean Medina, said United's pension investments
"have outperformed other similar large plans." She added:
"United has always operated our plans in the best interests of our
participants and beneficiaries, and believe our advisers act
similarly."

Companies do not generally invest their pension money themselves, but
instead farm out the work to an array of outside professionals. There are
pension consultants to help set an investment strategy and recommend the
money managers who actually pick the stocks and other particular
investments. There are actuaries to design benefits packages and
calculate how much companies need to contribute each year.

Custodial banks hold the assets in trust. Brokers execute trades. Once a
year, an outside auditor is supposed to review the plan and issue an
opinion about its conformity with generally accepted accounting
principles.

Problems can arise when there are undisclosed relationships among these
different service providers. 

"Asset allocation is very much driven by hidden financial
considerations," said Edward A. H. Siedle, the president of
Benchmark Financial Services, a company that audits pension funds. He
said one reason that pension funds tend to invest heavily in
high-turnover, active equities is that "those investments have
commissions and fees that can be shared with gatekeepers and others that
pave the way." Companies that sponsor pension plans can also reap
accounting gains if they increase the risk of their pension investments.

There are regulations and other legal safeguards intended to protect
pensions, and companies often cite the cost and difficulty of complying
with those rules. But much of this protective superstructure was designed
decades ago, before the rise of the independent money manager - and
before some of today's investment instruments were invented.

"Pensions are heavily regulated," Mr. Siedle said, "yet
it's a kind of funny regulation where the regulators who are responsible
for pensions really don't know much about managing money."

Thus there are rules to make sure that pension plans are not really tax
shelters in disguise, rules to make sure companies treat low- and
high-income workers equitably and, since 1989, rules to keep companies
from taking money out of pension funds and using it to run their
businesses. 

But there is no rule limiting aggressive investment strategies or
requiring companies that want to pursue them to pay more for their
pension insurance.

Congress sets the premium rates, and there are bills in both houses that
would raise them. But even now, the bills make no mention of studying,
much less capping, investment risk, or of setting insurance premiums
based on portfolio risk factors. 

The S.E.C. monitors investment advisers but has no legal standing to
enforce the pension rules. In a study, released in May, of pension
consultants, it found the industry vulnerable to abuse and referred a
dozen consultants to its investigative branch for possible enforcement
action.

But it did not name individual consulting firms it suspected of
conflicts, nor did it look specifically at how United's pension
consultant, the Russell Investment Group, performed in the years leading
up to the collapse of the airline's plans. Nor did the S.E.C. say if
Russell was one of the consultants now being investigated more
deeply.

A spokeswoman for Russell, Jennifer Tice, said the company had not
received any inquiries from S.E.C. since the commission completed its
general examination of the industry.

Ms. Tice said Russell could not explain why its name and fees were not
listed in the United plan's official records, noting that plan sponsors
file those records, not the consultant. United said Russell's omission
from its filings was an oversight. Both Russell and United declined to
say how Russell was compensated.

Ms. Tice, however, said Russell helps its clients answer any questions
raised by the S.E.C.'s findings, and regularly tells its consulting
clients in the United States about potential conflicts of interest and
Russell's policies for managing them. "Russell is committed to full
and timely disclosure of any potential conflicts of interest," she
said.

THE Internal Revenue Service provides yet another layer of protection to
pensions, but it has authority only over how companies design their
benefits and contribute money to their plans - not over whether they have
fulfilled their fiduciary duty to invest prudently. That is a job for the
Labor Department. 

In June, the Government Accountability Office warned of chronic weakness
in the Labor Department's enforcement of the pension law, and said the
department ought to be coordinating its efforts with the S.E.C.

The Labor Department also has authority over the disclosure of pension
data. It collects long lists of all the investments in each pension fund,
and of all of the money managers. But it does not track which money
managers were responsible for which investments.

That does not sit well with the United employees and retirees who are
waiting to find out how much of their pension benefits is covered by the
federal pension agency's insurance and how much they may lose.

"When I get a job, I put my name, my file number and my license in a
permanent record, and I'm accountable if something goes wrong," said
Bob Stone, a lead mechanic for United Airlines who retired this year.
"It's possible for every single aircraft mechanic in the country to
keep track of every single job they do. But we can't keep track of the
money managers. That's too complicated for us."

Because of limits on the government's pension insurance, they will
collectively lose benefits worth about $3.4 billion. Pilots will lose the
most because they were promised the richest pensions.

Finally, at the end of the regulatory patchwork is the Pension Benefit
Guaranty Corporation. Officials there have access to some of the most
current and detailed information about pensions, but they cannot do a lot
with it; a 1994 act of Congress requires them to keep it secret.

Officials at the pension agency sometimes confide that they feel like
they are running not an agency but a big garbage can, where companies can
dump their defunct pension plans, no questions asked.

Earlier this year, when United defaulted, Mr. Stone's union began to ask
questions about the money managers who handled its pension plan in its
final years - who they were and how they had made their decisions. That
labor group, the Aircraft Mechanics Fraternal Association, began to
represent United's mechanics only in 2003, after the airline had gone
bankrupt. It had no qualms about asking questions about how the pension
fund was handled when the previous union had some say over it.

"We have to learn what went wrong," Mr. Stone said. He added
that he was sure that some money managers "did their level best for
people," but that they all should stand by their decisions.
"Unless you separate it out and have accountability," Mr. Stone
said, "how are you ever going to reward the good guys and get rid of
the bad guys?"

This summer, the labor group wrote to Labor Secretary Elaine L. Chao and
Bradley D. Belt, executive director of the pension agency, asking for a
forensic audit of United's pension plans, "to determine whether any
of the parties providing financial services to the plans may have
contributed to their demise."

The letter, signed by the association's national director, O. V.
Delle-Femine, cited the recent S.E.C. report warning of potential
conflicts of interest among pension professionals, and it urged the
pension agency to find out whether tainted advice had played any role in
plan losses or underperformance.

"While the plan sponsor may be bankrupt, the parties that have been
dealing with the plan are not," Mr. Delle-Femine wrote. "It may
be possible to recover assets from these parties on behalf of the plan's
participants."

The association also called for an audit of the pension plans at

Northwest Airlines, where it also represents the mechanics. Northwest
is still running its pension plans but intends to freeze one of them, for
salaried employees, at the end of August, locking in employees' benefits
at current levels rather than allowing them to increase as they normally
would as people worked longer. 

Northwest is also seeking its unions' permission to freeze the other
three plans. The airline has been warning that if it does not get a break
on its pension funding requirements, it may have to declare bankruptcy
sometime next year. Bankruptcy is often a prelude to a pension
default.

Mr. Delle-Femine sent his letter in June. So far, said the association's
legislative liaison, Maryanne DeMarco, there has been no response from
the pension agency. The Labor Department told her that Ms. Chao could not
participate in an audit of Northwest's pension plans because she served
on that airline's board before her confirmation as labor secretary and
had recused herself from any involvement in its labor disputes. The Labor
Department has yet to respond to the request for an audit of United's
pension fund.

"We're all stunned that there isn't a review taking place,"
said Bill Moons, a United mechanic and the president of the union's local
in Denver. "We all want the truth."

He said he and Mr. Stone were two-time losers, having earlier lost
another chunk of their retirement savings when United first went bankrupt
and its employee stock ownership program lost all of its value.

The pilots' union had pushed hard for the employee stock ownership
program back in the 1980's, at about the same time that Mr. Wilsman, the
retired pilot, noticed that the airline had changed its previous
investment policy for people like him.

In the past, whenever a pilot retired, the airline used money from the
pension fund to buy him or her an annuity from an insurance company.
Annuities are lifelong streams of monthly payments, but insurance
companies pay them, not pension funds. 

Insurance companies are regulated differently, and they have no federal
guarantor like the Pension Benefit Guaranty Corporation to cover
potential losses. Therefore they tend to invest conservatively, in assets
that will not become wildly out of step with the payments they
owe.

Mr. Wilsman said he thought that an annuity was a surer thing than a
pension promise backed by stocks. He also thought United had violated the
terms of the pension plan, and maybe the pilots' labor contract, by
making the change unilaterally. 

He persuaded other retired pilots to join him in bringing a case before
the airline's pension board. Each retiree chipped in $25 to cover the
cost of a lawyer. At roughly the same time, Mr. Wilsman also filed a
grievance with the union.

But the retired pilots were no match for the siren song of the stock
market. The union, which handled their grievance, sided with the airline
on investment policy. It said it believed that a high-risk, high-return
strategy was best because, over time, it would lower United's
compensation costs and free up more money to raise salaries.

"The argument was that the new people could get more benefits if
they could do it by gambling than if the plan was secure," Mr.
Wilsman said.

A spokesman for the pilots' union said he could not recall Mr. Wilsman's
grievance and was unable to comment on it.

Ms. Medina, the United spokeswoman, said that United tried to buy all the
pilots' annuities in 1985, as part of a plan to terminate the pension
fund and take out the surplus assets for business purposes, but that the
pilots' union had blocked it. Two years later, when Mr. Wilsman and the
other retirees said they wanted annuities, United told them they were too
late, she said.

NOT only were United and the pilots' union lined up against the retirees,
Mr. Wilsman said. Even the arbitrator who was brought in to hear the case
before the pension board said that he couldn't see why the retirees
preferred an annuity to a pension, if the monthly payout was the same
either way.

"He said that as far as he was concerned, there was absolutely no
difference between an annuity and the company's promise," Mr.
Wilsman recalled. Afterward, he said, he thought he should have come up
with an example of why they weren't the same, but he was tired of arguing
with people dead-set against him. So he withdrew the grievance.

"It has always haunted me that I failed to cite an example," he
said in a recent telephone interview.

But the best example didn't happen until 18 years later.

Miklos A. Vasarhelyi
KPMG Professor of AIS
Director RARC / CARLAB
Rutgers University
315 Ackerson Hall
180 University Avenue
Newark, NJ 07102
(973) 353 5002
(201) 454 4377 (cell)
http://raw.rutgers.edu/mik los