Cummins Inc. Annual report pursuant to Section 13 and 15(d)

Annual report pursuant to Section 13 and 15(d)

PENSION AND OTHER POSTRETIREMENT BENEFITS

PENSION AND OTHER POSTRETIREMENT BENEFITS

12 Months Ended

Dec. 31, 2016

Compensation and Retirement Disclosure [Abstract]

Pension and Other Postretirement Benefits Disclosure [Text Block]

NOTE 8. PENSION AND OTHER POSTRETIREMENT BENEFITS

Pension Plans

We sponsor several contributory and noncontributory pension plans covering substantially all employees. Generally, hourly employee pension benefits are earned based on years of service and compensation during active employment while future benefits for salaried employees are determined using a cash balance formula. However, the level of benefits and terms of vesting may vary among plans. Pension plan assets are administered by trustees and are principally invested in fixed income securities and equity securities. It is our policy to make contributions to our various qualified plans in accordance with statutory and contractual funding requirements and any additional contributions we determine are appropriate.

Obligations, Assets and Funded Status

Benefit obligation balances presented below reflect the projected benefit obligation (PBO) for our pension plans. The changes in the benefit obligations, the various plan assets, the funded status of the plans and the amounts recognized in our Consolidated Balance Sheets for our significant pension plans at December 31 were as follows:



	Qualified and Non-Qualified Pension Plans
	U.S. Plans						U.K. Plans
In millions	2016			2015			2016			2015
Change in benefit obligation
Benefit obligation at the beginning of the year	$	2,533		$	2,579		$	1,390		$	1,522
Service cost	90			80			21			27
Interest cost	109			102			50			56
Actuarial loss (gain)	111			(76		)	316			(88		)
Benefits paid from fund	(175		)	(139		)	(55		)	(53		)
Benefits paid directly by employer	(16		)	(13		)	—			—
Plan amendments	9			—			—			—
Exchange rate changes	—			—			(271		)	(74		)
Benefit obligation at end of year	$	2,661		$	2,533		$	1,451		$	1,390
Change in plan assets
Fair value of plan assets at beginning of year	$	2,636		$	2,713		$	1,712		$	1,724
Actual return on plan assets	200			(8		)	402			20
Employer contributions	90			70			28			107
Benefits paid	(175		)	(139		)	(55		)	(53		)
Exchange rate changes	—			—			(334		)	(86		)
Fair value of plan assets at end of year	$	2,751		$	2,636		$	1,753		$	1,712
Funded status (including underfunded and nonfunded plans) at end of year	$	90		$	103		$	302		$	322
Amounts recognized in consolidated balance sheets
Pension assets - long-term	$	429		$	413		$	302		$	322
Accrued compensation, benefits and retirement costs - current liabilities	(13		)	(12		)	—			—
Pensions - long-term liabilities	(326		)	(298		)	—			—
Net amount recognized	$	90		$	103		$	302		$	322
Amounts recognized in accumulated other comprehensive loss
Net actuarial loss	$	770		$	689		$	172		$	228
Prior service cost (credit)	9			(1		)	—			—
Net amount recognized	$	779		$	688		$	172		$	228

In addition to the pension plans in the above table, we also maintain less significant defined benefit pension plans primarily in 14 other countries outside of the U.S. and the U.K. that comprise approximately 3 percent and 4 percent of our pension plan assets and obligations at December 31, 2016 and 2015, respectively. These plans are reflected in "Other liabilities and deferred revenue" on our Consolidated Balance Sheets. In 2016, we made $54 million of contributions to these plans including a contribution of $44 million to our German plans.

The following table presents information regarding total accumulated benefit obligation, PBO's and underfunded pension plans that are included in the preceding table:



	Qualified and Non-Qualified Pension Plans
	U.S. Plans				U.K. Plans
In millions	2016		2015		2016		2015
Total accumulated benefit obligation	$	2,625	$	2,499	$	1,366	$	1,311
Plans with accumulated benefit obligation in excess of plan assets
Accumulated benefit obligation	304		276		—		—
Plans with projected benefit obligation in excess of plan assets
Projected benefit obligation	339		311		—		—

Components of Net Periodic Pension Cost

The following table presents the net periodic pension cost under our plans for the years ended December 31:



	Qualified and Non-Qualified Pension Plans
	U.S. Plans									U.K. Plans
In millions	2016			2015			2014			2016			2015			2014
Service cost	$	90		$	80		$	66		$	21		$	27		$	24
Interest cost	109			102			105			50			56			63
Expected return on plan assets	(201		)	(189		)	(173		)	(71		)	(91		)	(84		)
Amortization of prior service credit	—			(1		)	(1		)	—			—			—
Recognized net actuarial loss	29			45			31			15			34			26
Net periodic pension cost	$	27		$	37		$	28		$	15		$	26		$	29

Other changes in benefit obligations and plan assets recognized in other comprehensive income for the years ended December 31 were as follows:



In millions	2016			2015			2014
Amortization of prior service credit	$	—		$	1		$	1
Recognized net actuarial loss	(44		)	(79		)	(57		)
Incurred actuarial loss	107			105			133
Foreign exchange translation adjustments	(28		)	(7		)	(18		)
Total recognized in other comprehensive income	$	35		$	20		$	59

Total recognized in net periodic pension cost and other comprehensive income	$	77		$	83		$	116

The amount in accumulated other comprehensive loss expected to be recognized as a component of net periodic pension cost during the next fiscal year is a net actuarial loss of $77 million.

Assumptions

The table below presents various assumptions used in determining the PBO for each year and reflects weighted-average percentages for the various plans as follows:



	Qualified and Non-Qualified Pension Plans
	U.S. Plans				U.K. Plans
	2016		2015		2016		2015
Discount rate	4.12	%	4.47	%	2.70	%	3.95	%
Compensation increase rate	4.87	%	4.88	%	3.75	%	3.75	%

The table below presents various assumptions used in determining the net periodic pension cost and reflects weighted-average percentages for the various plans as follows:



	Qualified and Non-Qualified Pension Plans
	U.S. Plans						U.K. Plans
	2016		2015		2014		2016		2015		2014
Discount rate	4.47	%	4.07	%	4.83	%	3.95	%	3.80	%	4.60	%
Expected return on plan assets	7.50	%	7.50	%	7.50	%	4.70	%	5.80	%	5.80	%
Compensation increase rate	4.87	%	4.88	%	4.91	%	3.75	%	4.25	%	4.50	%

Plan Assets

Our investment policies in the U.S. and U.K. provide for the rebalancing of assets to maintain our long-term strategic asset allocation. We are committed to its long-term strategy and do not attempt to time the market given empirical evidence that asset allocation is more critical than individual asset or investment manager selection. Rebalancing of the assets has and continues to occur. The rebalancing is critical to having the proper weighting of assets to achieve the expected total portfolio returns. We believe that our portfolio is highly diversified and does not have any significant exposure to concentration risk. The plan assets for our defined benefit pension plans do not include any of our common stock.

U.S. Plan Assets

For the U.S. qualified pension plans, our assumption for the expected return on assets was 7.5 percent in 2016. Projected returns are based primarily on broad, publicly traded equity and fixed income indices and forward-looking estimates of active portfolio and investment management. We expect additional positive returns from this active investment management. Based on the historical returns and forward-looking return expectations in a rising interest rate environment, we have elected to reduce our assumption to 7.25 percent in 2017.

The primary investment objective is to exceed, on a net-of-fee basis, the rate of return of a policy portfolio comprised of the following:



Asset Class	Target		Range
U.S. equities	13.0	%	+/-5.0%
Non-U.S. equities	5.0	%	+/-3.0%
Global equities	6.0	%	+/-3.0%
Total equities	24.0	%
Real estate	7.5	%	+2.5/-7.5%
Private equity/venture capital	7.5	%	+2.5/-7.5%
Opportunistic credit	4.0	%	+6.0/-4.0%
Fixed income	57.0	%	+/-5.0%
Total	100.0	%

The fixed income component is structured to represent a custom bond benchmark that will closely hedge the change in the value of our liabilities. This component is structured in such a way that its benchmark covers approximately 100 percent of the plan's exposure to changes in its discount rate (AA corporate bond yields). In order to achieve a hedge on more than the targeted 57 percent of plan assets invested in fixed income securities, our Benefits Policy Committee (BPC) permits the fixed income managers, other managers or the custodian/trustee to utilize derivative securities, as part of a liability driven investment strategy to further reduce the plan's risk of declining interest rates. However, all managers hired to manage assets for the trust are prohibited from using leverage unless specifically discussed with the BPC and approved in their guidelines.

U.K. Plan Assets

For the U.K. qualified pension plans, our assumption for the expected return on assets was 4.7 percent in 2016. The methodology used to determine the rate of return on pension plan assets in the U.K. was based on establishing an equity-risk premium over current long-term bond yields adjusted based on target asset allocations. Our strategy with respect to our investments in these assets is to be invested in a suitable mixture of return-seeking assets such as equities and real estate and liability matching assets such as bonds with a long-term outlook. Therefore, the risk and return balance of our U.K. asset portfolio should reflect a long-term horizon. To achieve these objectives we have established the following targets:



Asset Class	Target
Global equities	23.0	%
Real estate	5.0	%
Re-insurance	8.0	%
Corporate credit instruments	7.5	%
Fixed income	56.5	%
Total	100.0	%

As part of our strategy in the U.K. we have not prohibited the use of any financial instrument, including derivatives. Based on the above discussion, we have elected an assumption of 4.5 percent in 2017.

Fair Value of U.S. Plan Assets

The fair values of U.S. pension plan assets by asset category were as follows:



	Fair Value Measurements at December 31, 2016
In millions	Quoted prices in active markets for identical assets (Level 1)		Significant other observable inputs (Level 2)		Significant unobservable inputs (Level 3)		Total
Equities
U.S.	$	145	$	—	$	—	$	145
Non-U.S.	125		—		—		125
Fixed income
Government debt	—		570		—		570
Corporate debt
U.S.	—		497		—		497
Non-U.S.	—		84		—		84
Asset/mortgaged backed securities	—		58		—		58
Net cash equivalents⁽¹⁾	18		20		—		38
Derivative instruments⁽²⁾	—		9		—		9
Private equity and real estate⁽³⁾	—		—		212		212
Net plan assets subject to leveling	$	288	$	1,238	$	212	$	1,738
Pending trade/purchases/sales							(83		)
Accruals⁽⁴⁾							12
Investments measured at net asset value							1,084
Net plan assets							$	2,751



	Fair Value Measurements at December 31, 2015
In millions	Quoted prices in active markets for identical assets (Level 1)		Significant other observable inputs (Level 2)		Significant unobservable inputs (Level 3)		Total
Equities
U.S.	$	96	$	—	$	—	$	96
Non-U.S.	130		—		—		130
Fixed income
Government debt	—		533		—		533
Corporate debt
U.S.	—		406		—		406
Non-U.S.	—		80		—		80
Asset/mortgaged backed securities	—		56		—		56
Net cash equivalents ⁽¹⁾	42		10		—		52
Derivative instruments⁽²⁾	—		3		—		3
Private equity and real estate ⁽³⁾	—		—		203		203
Net plan assets subject to leveling	$	268	$	1,088	$	203	$	1,559
Pending trade/purchases/sales							(27		)
Accruals ⁽⁴⁾							10
Investments measured at net asset value							1,094
Net plan assets							$	2,636

____________________________________________________


⁽¹⁾	Cash equivalents include commercial paper, short-term government/agency, mortgage and credit instruments.


⁽²⁾	Derivative instruments include interest rate swaps and credit default swaps.


⁽³⁾	The instruments in private equity, real estate and insurance funds, for which quoted market prices are not available, are valued at their estimated fair value as determined by applicable investment managers or by audited financial statement of the funds.


⁽⁴⁾	Accruals include interest or dividends that were not settled at December 31.

Certain of our assets are valued based on their respective net asset value (NAV) (or its equivalent), as an alternative to estimated fair value due to the absence of readily available market prices. The fair value of each such investment category was as follows:


•	U.S. and Non-U.S. Equities ($511 million and $335 million at December 31, 2016 and 2015, respectively) - These commingled funds have observable NAVs provided to investors and provide for liquidity either immediately or within a couple of days.


•	Government Debt ($178 million and $287 million at December 31, 2016 and 2015, respectively) - These commingled funds have observable NAVs provided to investors and provide for liquidity either immediately or within a couple of days.


•	U.S. and Non-U.S. Corporate Debt ($265 million and $346 million at December 31, 2016 and 2015, respectively) - These commingled funds have observable NAVs provided to investors and provide for liquidity either immediately or within a couple of days.


•	Real Estate ($129 million and $119 million at December 31, 2016 and 2015, respectively) - This asset type represents different types of real estate including development property, industrial property, individual mortgages, office property, property investment companies, and retail property. These funds are valued using NAVs and allow quarterly or more frequent redemptions.


•	Asset/Mortgage Backed Securities ($1 million and $7 million at December 31, 2016 and 2015, respectively) - This asset type represents investments in fixed- and floating-rate loans. These funds are valued using NAVs and allow quarterly or more frequent redemptions.

The reconciliation of Level 3 assets was as follows:



	Fair Value Measurements Using Significant Unobservable Inputs (Level 3)
In millions	Private Equity			Real Estate			Total
Balance at December 31, 2014	$	148		$	54		$	202
Actual return on plan assets
Unrealized gains on assets still held at the reporting date	17			8			25
Purchases, sales and settlements, net	(22		)	(2		)	(24		)
Balance at December 31, 2015	143			60			203
Actual return on plan assets
Unrealized gains on assets still held at the reporting date	6			6			12
Purchases, sales and settlements, net	(1		)	(2		)	(3		)
Balance at December 31, 2016	$	148		$	64		$	212

Fair Value of U.K. Plan Assets

In July 2012, the U.K. pension plan purchased an insurance contract that will guarantee payment of specified pension liabilities. The contract defers payment for 10 years and is included in the table below in Level 3 for years ended December 31, 2016 and 2015 at a value of $439 million and $445 million, respectively.

The fair values of U.K. pension plan assets by asset category were as follows:



	Fair Value Measurements at December 31, 2016
In millions	Quoted prices in active markets for identical assets (Level 1)		Significant other observable inputs (Level 2)		Significant unobservable inputs (Level 3)		Total
Equities
U.S.	$	—	$	174	$	—	$	174
Non-U.S.	—		193		—		193
Fixed income
Net cash equivalents ⁽¹⁾	24		—		—		24
Private equity, real estate and insurance ⁽²⁾	—		—		613		613
Net plan assets subject to leveling	$	24	$	367	$	613	$	1,004
Investments measured at net asset value							749
Net plan assets							$	1,753



	Fair Value Measurements at December 31, 2015
In millions	Quoted prices in active markets for identical assets (Level 1)		Significant other observable inputs (Level 2)		Significant unobservable inputs (Level 3)		Total
Equities
U.S.	$	—	$	250	$	—	$	250
Non-U.S.	—		269		—		269
Fixed income
Corporate debt non-U.S.	—		45		—		45
Net cash equivalents ⁽¹⁾	33		—		—		33
Private equity, real estate and insurance ⁽²⁾	—		—		601		601
Net plan assets subject to leveling	$	33	$	564	$	601	$	1,198
Investments measured at net asset value							514
Net plan assets							$	1,712

_____________________________________________________


⁽¹⁾	Cash equivalents include commercial paper, short-term government/agency, mortgage and credit instruments.


⁽²⁾	The instruments in private equity, real estate and insurance funds, for which quoted market prices are not available, are valued at their estimated fair value as determined by applicable investment managers or by audited financial statement of the funds.

Certain of our assets are valued based on their respective NAV (or its equivalent), as an alternative to estimated fair value due to the absence of readily available market prices. The fair value of each such investment category was as follows:


•	U.S. and Non-U.S. Corporate Debt ($655 million and $458 million at December 31, 2016 and 2015, respectively) - These commingled funds have observable NAVs provided to investors and provide for liquidity either immediately or within a couple of days.


•	Re-insurance ($56 million and $56 million at December 31, 2016 and 2015, respectively) - This commingled fund has a NAVs that is determined on a monthly basis and the investment may be sold at that value.


•	Managed Futures Funds ($38 million and $0 million at December 31, 2016 and 2015, respectively) - These commingled funds invest in commodities, fixed income and equity securities. They have observable NAVs provided to investors and provide for liquidity either immediately or within a couple of days.

The reconciliation of Level 3 assets was as follows:



	Fair Value Measurements Using Significant Unobservable Inputs (Level 3)
In millions	Insurance			Real Estate			Private Equity		Total
Balance at December 31, 2014	$	462		$	61		$	81	$	604
Actual return on plan assets
Unrealized gains on assets still held at the reporting date	6			7			10		23
Purchases, sales and settlements, net	(23		)	(11		)	8		(26		)
Balance at December 31, 2015	445			57			99		601
Actual return on plan assets
Unrealized (losses) gains on assets still held at the reporting date	(6		)	(7		)	15		2
Purchases, sales and settlements, net	—			7			3		10
Balance at December 31, 2016	$	439		$	57		$	117	$	613

Level 3 Assets

The investments in an insurance contract, venture capital, private equity, opportunistic credit and real estate funds, for which quoted market prices are not available, are valued at their estimated fair value as determined by applicable investment managers or by quarterly financial statements of the funds. These financial statements are audited at least annually. In conjunction with our investment consultant, we monitor the fair value of the insurance contract as periodically reported by our insurer and their counterparty risk. The fair value of all real estate properties, held in the partnerships, are valued at least once per year by an independent professional real estate valuation firm. Fair value generally represents the fund's proportionate share of the net assets of the investment partnerships as reported by the general partners of the underlying partnerships. Some securities with no readily available market are initially valued at cost, utilizing independent professional valuation firms as well as market comparisons with subsequent adjustments to values which reflect either the basis of meaningful third-party transactions in the private market or the fair value deemed appropriate by the general partners of the underlying investment partnerships. In such instances, consideration is also given to the financial condition and operating results of the issuer, the amount that the investment partnerships can reasonably expect to realize upon the sale of the securities and any other factors deemed relevant. The estimated fair values are subject to uncertainty and therefore may differ from the values that would have been used had a ready market for such investments existed and such differences could be material.

Estimated Future Contributions and Benefit Payments

We plan to contribute approximately $134 million to our defined benefit pension plans in 2017. The table below presents expected future benefit payments under our pension plans:



	Qualified and Non-Qualified Pension Plans
In millions	2017		2018		2019		2020		2021		2022 - 2026
Expected benefit payments	$	241	$	237	$	243	$	249	$	254	$	1,322

Other Pension Plans

We also sponsor defined contribution plans for certain hourly and salaried employees. Our contributions to these plans were $68 million, $74 million and $73 million for the years ended December 31, 2016, 2015 and 2014.