* Tie-up to make world's third largest airline by revenue
* Deal still pending regulatory, shareholder approval
* Merged entity to fly by year-end
* BA shares up 0.7 pct, Iberia 0.4 pct lower
(Adds union comments, updates shares, more details)
By Rhys Jones and Tracy Rucinski
MADRID/LONDON, April 8 (Reuters) - British Airways BAY.L and Spain's Iberia IBLA.MC signed an $8 billion merger to create the world's third-largest airline on Thursday, bringing a three-way tie-up with American Airlines AMR.N a step closer.
The deal between BA and Iberia, which the pair hope to complete by December, is designed to help BA and Iberia stem over $1 billion of combined annual losses following the worst industry downturn in decades.
They hope to cut costs by 400 million euros a year to better compete with larger rivals Lufthansa (LHAG.DE) and Air France (AIRF.PA) and budget carriers such as Ryanair (RYA.I).
The combined group, to be majority owned by BA shareholders, ends the British company's long pursuit of Iberia and positions the companies for further consolidation.
BA, Iberia and American, members of the Oneworld alliance, want to deepen the pact to take advantage of the U.S./EU "Open Skies" agreement, which liberalises transatlantic aviation.
"The tie-up with American is the next thing on BA and Iberia's agenda now and this agreement brings that closer but they are probably looking at European and Asian carriers too," said Davy Stockbrokers analyst Stephen Furlong.
"There are too many airlines in the world and bigger will be better in the future. BA will hope that this is the start of many more tie-ups."
On Wednesday, sources said United Airlines UAUA.O was in merger talks with US Airways LCC.N in a deal that could create the second-largest carrier in the U.S. [ID:nN07137095]
The Oneworld alliance will hold a news conference in Los Angeles later on Thursday to announce a joint venture between American and Japan Airlines 9205.T on Pacific routes, an industry source said. BA's Chief Executive Willie Walsh and Iberia boss Antonio Vazquez will both be present.
Vazquez, who will chair the merged International Airlines Group, said a combined BA-Iberia would "participate in future industry consolidation."
BA and Iberia will continue to operate under their original brands -- mirroring the structure of the 2004 Air France-KLM merger, in which both carriers kept their own fleets and networks but are owned by a common holding company.
"The name itself reflects a longer term intention to add more airlines without favouring any one company," said Societe Generale analyst Jonathan Wober.
By 1215 GMT, BA shares were up 0.7 percent at 239.6 pence, while Iberia shares fell 0.4 percent to 2.61 euros.
For a graphic comparing BA and Iberia, click on
The merger will combine BA's strong position in north Atlantic traffic with Iberia's Latin American business, which could be reinforced by the planned American Airlines alliance.
BA and Iberia's target to save 400 million euros of annual costs by the end of the fifth year will involve cutting jobs and less profitable shorthaul flights.
BA has recently faced strikes by its cabin crew over pay and jobs which it said were threatening its future.
"I'd imagine the 400 million euros is a low-ball figure, but with BA union action they can't be much more aggressive at this point. The whole reason behind this merger is revenue and cost synergies," said an analyst in Spain who asked not to be named.
"We accept the logic of the merger in the challenging economic climate for aviation, said Steve Turner, UK union Unite's national officer for civil aviation. "We support this move - but not any cost."
Spanish unions welcomed the tie-up, which still needs regulatory and shareholder approval.
"The European air industry is moving toward three large players ... and the (BA) deal's being done in a way that respects Iberia's current labour agreements," a spokesman for Spain's second-largest union UGT said.
Once finalised BA will have a 56 percent share and Iberia 44 percent and each airline will appoint seven members to the board.
BA's $5.6 billion pension deficit could still scupper the deal after Iberia 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's Walsh will be CEO of the new group, to be headquartered in London with annual revenues of some $20 billion.
The pair began merger talks in July 2008 in response to slowing passenger demand but industry body IATA last week said airlines were slowly climbing out of recession. [ID:nLDE62T0N1].
For a factbox on how a combined British Airways and Iberia would look, click here [ID:nLDE63708E]
For a Timeline on talks between the companies, click here [ID:nLDE6370BM]
(Editing by Elaine Hardcastle)