LONDON, April 14 (Reuters) – British Airways’ (BAY.L) $5.6-billion pension deficit could still be a deal breaker in its merger with Spain’s Iberia (IBLA.MC) to create the world’s third-largest airline.

Iberia has reserved the right to walk away if the UK pensions regulator forces bigger costs on BA to sort out the shortfall than the Spanish carrier thinks is affordable.

BA operates two defined benefit pension funds, the Airways Pension Scheme (APS), closed in 1984 and mainly made up of pensioners, and the larger New Airways Pension Scheme (NAPS), which closed in 2003 but which still has 30,000 staff in it. Newer recruits have been offered a cheaper defined contribution pension.

BA last month reached agreement with unions on the future of its pension fund, which will see members’ contributions rise but keep BA’s annual payment at 330 million pounds.

The proposals need to be accepted by the trustees and the pensions regulator when BA presents its recovery plan in June.

Here are the options available to BA:

CHANGE IN INVESTMENT STRATEGY

In 2008/09, the 6 billion pounds NAPS scheme invested more than half of its assets in equities, meaning the fund was exposed to recent market volatility. The 5.9 billion pound APS, however, invested most of its assets in bonds.

Changing the current investment philosophy would be a long-term strategy and consultants believe trustees would need to balance the desire for high returns to help cut the deficit with the need for low volatility.

Michael Berg, a partner at consultancy Lane, Clark & Peacock, which does not advise BA trustees, said an all-bond strategy could cost an extra 4 billion pounds in contributions over a number of years.

Trustees could also agree on a pre-determined set of returns with BA, which would trigger a switch to different investments — an increasingly popular option with funds because they can quickly take advantage of market changes, said Berg.

“This seems to be the most realistic option at this stage, and I am fairly certain it has been on the agenda for the trustees,” said Lorant Porkolab, a senior consultant at pension scheme advisory firm Punter Southall, which does not advise BA.

INSURING LIABILITIES, KEEPING ASSETS (BUY-IN) The trustees could select one or more insurer to take over part of the scheme’s liabilities. This would be a clean-cut option, quickly relieving BA of some of its pension burden but enabling trustees to keep pension assets.

Such a move would be expensive given insurers would charge a premium above the level of liabilities.

These deals are usually limited to retirees, because liabilities linked to this group are easier to calculate.

Other companies have done buy-in deals, but a BA buy-in would be the largest of its kind.

“In theory the probability of this scenario can be slightly higher than the likelihood of a full buy-out. However even this option is very unlikely at this stage,” said Punter Southall’s Porkolab.

INSURER TO TAKE ON PENSION RESPONSIBILITIES (BUY-OUT).

A buy-out deal would allow BA to take pension liabilities off its balance sheet but would also be the most expensive option for the airline as insurers typically charge a hefty premium to shoulder such large deficit.

Additionally, analysts believe BA’s trustees would be reluctant to expose the fund to a counterparty risk, despite the fact the risk would be mitigated by FSA rules on reserves insurers must have to write business.

Oddo Securities analyst Yan Derocles believes BA is unlikely to choose the pricier option “given the cash flow needed to plug the pension deficit and for the renewal of the fleet”.

HEDGE LONGEVITY, INFLATION RISK (SWAPS)

The sustainability of defined benefit pension funds not only depends on their investment strategy and the strength of their sponsors but also on elements such as inflation and members’ life expectancy.

Pension funds can hedge these risks using derivatives such as swaps with a third party, like investment banks.

A swap would not involve an immediate cash payment but would expose the pension fund to third-party risk.

Trustees may decide to limit the counterparty risk by pledging collateral such as existing assets. This option would still entitle the schemes to benefit from the returns.

Independent consultant John Ralfe said this could be done only “from a position of strength”, adding that the chance of BA doing this was “pretty low”.

EARMARKING ASSETS FOR PENSION USE (CONTINGENT ASSETS)

BA last year made available to both its defined benefit funds 330 million pounds through letters of credit, secured “on certain aircraft.”

In July both schemes agreed to replace such guarantees with alternative securities to help improve BA’s borrowing capability.

“The trustees do not have a track record of squeezing the company. This option is a zero percent possibility,” Ralfe said.

(Editing by Sitaraman Shankar)