UPDATE 5-BA, Iberia merger hinges on pension deficit

* BA pension deficit still main obstacle to merger

* Iberia posts bigger nine-month operating loss

* Iberia's passenger traffic down 5.1 pct in October

* BA shares close 1 pct higher, Iberia down over 3 pct

(Adds reaction from Spanish unions, updates share prices)

By Tracy Rucinski and Rhys Jones

MADRID, Nov 13 (Reuters) - British Airways' (BAY.L) pension fund deficit could yet scupper its planned merger with Spain's Iberia (IBLA.MC), as the UK airline still has to agree the size of the multi-billion pound shortfall with the fund's trustees.

Iberia, which on Friday posted a bigger than expected nine-month operating loss, agreed with BA on Thursday to create a group with a combined market value of $7 billion as they continue to battle the worst industry downturn in decades. [ID:nLC092017]

But BA's pension deficit was one of the main stumbling blocks in the 16-month merger talks and was a key negotiating point for Iberia, which is reserving the right to back out of the deal if the funding hole turns out to be bigger than the 3 billion pounds ($5 billion) which analysts have forecast.

BA pension trustees undertook a triennial review of the pension scheme earlier this year but the results have yet to be announced, with BA saying it expects to agree a figure with the trustees in the next two to three months.

"The market will be looking at the discount rate used by BA's trustees to calculate its pension liabilities. You'd expect them to use a favourable one to help push the deal through though, especially since the deficit is bigger than its market value right now" a London-based analyst said.

"There's still a risk that the deal will fall through. It's all hanging on BA's negotiating weight with the trustees over its pension," a Madrid-based equities sales trader said.

Iberia's shares closed 3.15 percent lower at 2.15 euros, after Thursday's 12 percent gain, while BA was 0.93 percent higher at 217 pence.

Some analysts said they were surprised that the terms of a deal had even been announced before the pension issue has been resolved.

Analysts believe BA could insure all or part of its liabilities through a buy-out deal with a specialised insurer or hedge specific risks such as the longevity of pensioners through a swap deal or pledge contingent assets such as its real estate.

The new company will combine British Airways' strong position in Europe-to-North America traffic with Iberia's Latin American business, and will potentially be reinforced by a planned alliance with AMR Corp's (AMR.N) American Airlines.