Explaining the burden of "legacy costs"

With all the discussion about the domestic automakers' future lately, a few of our readers have left comments requesting some additional background on the situation; primarily, the history of the oft-touted "legacy costs" and how they affect the Big 3's survival.

The legacy costs have their roots in the concept of "cradle-to-grave" care provided to industrial workers by their lifelong employers. Such a system utilized employer-funded pensions to provide retirement income and catastrophic injury coverage for employees, and also ensured workers that they would receive a high level of health care coverage upon retirement. This arrangement minimized the burden on government-funded social security programs and provided significant incentive for loyalty on behalf of the employee, but also depended on steady growth within the manufacturing sector - an assumption that, as we now see all too clearly, turned out to be wrong.

Follow the jump for a breakdown on what automakers could do to address the burden of legacy costs and what they actually are doing.

In addition to requiring a steady base of active employees, pension plans also depend on deft actuarial footwork, and frankly most plans have not adapted well to the increased longevity of retirees. As stated in the Wikipedia entry for pensions, "Because of the J-shaped accrual rate, the cost of a defined benefit plan is very low for a young workforce, but extremely high for an older workforce. This age bias, the difficulty of portability and open ended risk, makes defined benefit plans better suited to large employers with less mobile workforces, such as the public sector." Put into fewer words, an older, shrinking active workforce dramatically increases the cost of employer-funded pension plans. Roll soaring health-care costs into the equation, and a huge drain is placed on profitability.

Membership in the United Auto Workers has declined to about a third of its peak in the late 1960s. General Motors, in the span of twenty years (1985 to 2005), went from 811,000 employees to only 324,000, giving GM 2.5 retirees per active worker (Chrysler lies on the other end of the spectrum, with slightly less than one retiree per employee). It is this shrinkage of the active workforce and the decline in revenue - brought on by the continued loss of market share and the consequential drop in production - that has placed the Big 3 into such a conundrum.

So, what can be done? Well, considering that two-thirds of health-care costs go to retirees and that there is no contractual obligation to provide this care to retirees, the automakers could simply stop paying for it. This would almost assuredly cause a massive strike, so it's not likely a practical solution in the short term. The UAW has allowed a reduction in retiree health care benefits in the last year, but cuts above and beyond what have already been yielded by the union seem unlikely at this time. There is also no easy way to decrease the pension liabilities, short of declaring bankruptcy and dumping the pension plan on the federal Pension Benefit Guarantee Corporation. In fact, Congress is working on plans to tighten pension rules, which stands to wipe out the market capitalization of the Big 3 and would place an even larger burden on future profits.

The best approach at this point is likely what the automakers are already doing - reduce other fixed costs via worker buy-outs and a retooling of labor contracts, and working on recapturing market share (or at least arresting the slide) such that revenues can be maintained. Once this is accomplished, it's a waiting game, as the problem eventually fades away as retirees pass on from this life. The question, of course, is whether the Big 3 can survive long enough, and we likely won't know the answer to that for several years. The focus still comes back around to the product side of the equation, though, as showroom success is absolutely essential to dealing with this problem.