"Clearly the pension issue is foremost in our minds," AC President and CEO Montie Brewer recently told analysts and reporters. "Pension rules in Canada are not aligned with the US. . .The rules have to be realigned."

Several US airlines used Chapter 11 bankruptcy reorganization earlier this decade to terminate defined-benefit pension plans or substantially reduce benefits, and shifted a large portion of financial obligations related to those pensions to the US Pension Benefit Guaranty Corp. Further relief was provided in 2006 when the US Congress passed legislation that significantly reformed US pension law and specifically gave airlines extra time to fund defined benefit retirement programs. The law gave all US companies seven years from 2008 to fully fund pension programs. But carriers that had frozen their plans, such as Northwest Airlines and Delta Air Lines, got 10 additional years (17 overall) to fund their plans fully. Others got three additional years (10 overall) to complete funding.

In contrast, Canada's federal pension regulations remain among the tightest in the world and force companies to fund plans fully, with a five-year repayment requirement strictly enforced. AC contributed C$456 million ($364 million) to funding employees' defined plans in 2008 and faces a C$3.2 billion pension fund solvency deficit.

"Without further relief from the federal government, other corrective measures or fundamental changes, these costs will prove unsustainable," Brewer warned earlier this month. "It is imperative. . .for the federal government to make permanent changes to federal pension regulations."

Canadian Finance Minister Jim Flaherty last year said the government would extend the pension repayment period from five to 10 years. But the alteration comes with a major caveat: Companies must receive consent from their workers or obtain a letter of credit to make up the difference. For Canada's biggest corporations, such as AC, that makes the extension nearly impossible to get. Workers are unlikely to agree and letters of credit are difficult to come by in the current economic environment.

Under pressure from a host of companies warning of crippling pension costs, including AC and General Motors' Canadian division, Ottawa now is undertaking a formal review of its pension regulations. Brewer said the review will be ongoing throughout the spring and summer and he hopes to see "results" by fall.

He has declined to make specific recommendations publicly as to how the pension laws should be changed. Analysts say Canadian companies are looking for more flexibility, both in terms of repayment periods and in the way deficits are calculated, and for the government potentially to provide relief by sharing funding obligations so that companies don't have all the risk. Brewer said that "other carriers [such as US airlines] who do not face the same high pension funding obligations that we do" have a big competitive advantage during the financial downturn.

Complicating matters more is that ACE Aviation Holdings, which was created in 2004 as part of the airline's restructuring and still holds a 75% stake in AC, is attempting to dissolve this year. While AC has said it welcomes the chance to operate as an independent company, the Air Canada Pilots Assn. is citing the planned dissolution to press the carrier on pension funding. ACPA formally has asked Canada's Office of the Superintendent of Financial Institutions "to intervene in the wind-up of the airline's parent holding company. . .because of concerns that the transaction would put pension plans at risk." ACPA President Andy Wilson said, "Air Canada's pensions [are] in a very vulnerable position." The union has asked OSFI to require that ACE and AC "meet their pension obligations before the wind-up of ACE is completed."

All the talk about AC's "ballooning pension obligations," in the words of Raymond James analyst Ben Cherniavsky, has added to a growing unease over the airline's financial health. AC reported a 2008 net loss of C$1.03 billion, and Brewer promised that it will target additional cost reductions of C$120 million in 2009 to counter a weak revenue environment. He insisted the airline is "well positioned" for an economic recovery and noted that it ended 2008 with more than C$1 billion in cash and cash equivalents.

Versant Partners analyst Cameron Doerksen countered in a research note, however, that "given the state of credit markets and a deteriorating aircraft financing market, the ability to generate cash from these assets is questionable." Citing the pension issue and other challenges, he downgraded AC's stock to "sell."