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, 2018

Retirement Benefits [Abstract]

Pension and Other Postretirement Benefits Disclosure

NOTE 11. PENSIONS AND OTHER POSTRETIREMENT BENEFITS

Pension Plans

We sponsor several pension plans covering substantially all employees. Generally, pension benefits for salaried employees are determined as a function of employee’s compensation. Pension benefits for most hourly employees are determined similarly and as a function of employee’s compensation, with the exception of a small group of hourly employees whose pension benefits were grandfathered in accordance with agreements with their union representation and are based on their years of service and compensation during active employment. The level of benefits and terms of vesting may vary among plans and are offered in accordance with applicable laws. Pension plans assets are administered by trustees and are principally invested in fixed income security 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	2018			2017			2018				2017
Change in benefit obligation
Benefit obligation at the beginning of the year	$	2,765		$	2,661		$	1,662			$	1,451
Service cost	120			107			29				26
Interest cost	98			106			41				40
Actuarial (gain) loss	(212		)	61			(46		)		53
Benefits paid from fund	(193		)	(155		)	(62		)		(54		)
Benefits paid directly by employer	(16		)	(15		)	—				—
Plan amendment	—			—			15			⁽¹⁾	—
Exchange rate changes	—			—			(89		)		146
Benefit obligation at end of year	$	2,562		$	2,765		$	1,550			$	1,662
Change in plan assets
Fair value of plan assets at beginning of year	$	3,166		$	2,751		$	1,960			$	1,753
Actual return on plan assets	(36		)	351			(33		)		78
Employer contributions	—			219			21				9
Benefits paid	(193		)	(155		)	(62		)		(54		)
Exchange rate changes	—			—			(104		)		174
Fair value of plan assets at end of year	$	2,937		$	3,166		$	1,782			$	1,960
Funded status (including unfunded plans) at end of year	$	375		$	401		$	232			$	298
Amounts recognized in consolidated balance sheets
Pension assets - long-term	$	697		$	745		$	232			$	298
Accrued compensation, benefits and retirement costs - current liabilities	(14		)	(14		)	—				—
Pensions - long-term liabilities	(308		)	(330		)	—				—
Net amount recognized	$	375		$	401		$	232			$	298
Amounts recognized in accumulated other comprehensive loss
Net actuarial loss	$	635		$	649		$	230			$	207
Prior service cost	8			8			16				—
Net amount recognized	$	643		$	657		$	246			$	207

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⁽¹⁾Guaranteed minimum pension benefits to equalize certain pension benefits between men and women per the United Kingdom court decision.

In addition to the pension plans in the above table, we also maintain less significant defined benefit pension plans in 14 other countries outside of the U.S. and the U.K. that comprise approximately 4 percent and 5 percent of our pension plan assets and obligations, respectively, at December 31, 2018. These plans are reflected in "Other liabilities" on our Consolidated Balance Sheets. In 2018 and 2017, we made $11 million and $11 million of contributions to these plans, respectively.

The following table presents information regarding total accumulated benefit obligation (ABO), the ABO and fair value of plan assets for defined benefit pension plans with ABO in excess of plan assets and the PBO and fair value of plan assets for defined benefit pension plans with PBO in excess of plan assets:



	Qualified and Non-Qualified Pension Plans
	U.S. Plans				U.K. Plans
In millions	2018		2017		2018		2017
Total accumulated benefit obligation	$	2,544	$	2,745	$	1,473	$	1,569
Plans with accumulated benefit obligation in excess of plan assets
Accumulated benefit obligation	304		323		—		—
Plans with projected benefit obligation in excess of plan assets
Projected benefit obligation	322		344		—		—

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	2018			2017			2016			2018			2017			2016
Service cost	$	120		$	107		$	90		$	29		$	26		$	21
Interest cost	98			106			109			41			40			50
Expected return on plan assets	(196		)	(204		)	(201		)	(69		)	(70		)	(71		)
Amortization of prior service cost	1			—			—			—			—			—
Recognized net actuarial loss	33			37			29			29			40			15
Net periodic pension cost	$	56		$	46		$	27		$	30		$	36		$	15

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



In millions	2018			2017			2016
Recognized net actuarial loss	$	(62	)	$	(77	)	$	(44	)
Incurred actuarial loss (gain)	91			(40		)	107
Foreign exchange translation adjustments	(5		)	30			(28		)
Total recognized in other comprehensive loss (income)	$	24		$	(87	)	$	35

Total recognized in net periodic pension cost and other comprehensive loss (income)	$	110		$	(5	)	$	77

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
	2018		2017		2018		2017
Discount rate	4.36	%	3.66	%	2.80	%	2.55	%
Cash balance crediting rate	4.03	%	4.27	%	—		—
Compensation increase rate	3.00	%	2.99	%	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
	2018		2017		2016		2018		2017		2016
Discount rate	3.66	%	4.12	%	4.47	%	2.55	%	2.70	%	3.95	%
Expected return on plan assets	6.50	%	7.25	%	7.50	%	4.00	%	4.50	%	4.70	%
Compensation increase rate	3.00	%	4.87	%	4.87	%	3.75	%	3.75	%	3.75	%

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 this 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 6.5 percent in 2018. 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 6.25 percent in 2019.

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	7.0	%	+5.0/ -5.0%
Non-U.S. equities	2.0	%	+3.0/ -2.0%
Global equities	6.0	%	+3.0/ -3.0%
Total equities	15.0	%
Real estate	6.5	%	+3.5/ -6.5%
Private equity/venture capital	6.5	%	+3.5/ -6.5%
Opportunistic credit	4.0	%	+6.0/ -4.0%
Fixed income	68.0	%	+5.0/ -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 68 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 4.0 percent in 2018. 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, real estate and liability matching assets such as group annuity insurance contracts and duration matched bonds. 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/private markets	5.0	%
Reinsurance	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. As in the U.S. plan, derivatives may be used to better match liability duration and are not used in a speculative way. The 56.5 percent fixed income component is structured in a way that covers approximately 80 percent of the plan's exposure to changes in its discount rate. Based on the above discussion, we have elected an assumption of 4.0 percent in 2019.

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, 2018
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.	$	77	$	—	$	—	$	77
Non-U.S.	42		—		—		42
Fixed income
Government debt	—		38		—		38
Corporate debt
U.S.	—		323		—		323
Non-U.S.	—		15		—		15
Asset/mortgaged backed securities	—		5		—		5
Net cash equivalents⁽¹⁾	175		17		—		192
Private equity and real estate⁽³⁾	—		—		316		316
Net plan assets subject to leveling	$	294	$	398	$	316	$	1,008
Pending trade/purchases/sales							9
Accruals⁽⁴⁾							5
Investments measured at net asset value							1,915
Net plan assets							$	2,937



	Fair Value Measurements at December 31, 2017
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.	$	102	$	—	$	—	$	102
Non-U.S.	56		—		—		56
Fixed income
Government debt	—		691		—		691
Corporate debt
U.S.	—		590		—		590
Non-U.S.	—		73		—		73
Asset/mortgage backed securities	—		78		—		78
Net cash equivalents ⁽¹⁾	50		25		—		75
Derivative instruments⁽²⁾	—		3		—		3
Private equity and real estate ⁽³⁾	—		—		246		246
Net plan assets subject to leveling	$	208	$	1,460	$	246	$	1,914
Pending trade/purchases/sales							(96		)
Accruals ⁽⁴⁾							12
Investments measured at net asset value							1,336
Net plan assets							$	3,166

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⁽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 and real estate, 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 statements 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 ($343 million and $428 million at December 31, 2018 and 2017, respectively) - These commingled funds have observable NAVs provided to investors and provide for liquidity either immediately or within a couple of days.


•	Government Debt ($602 million and $347 million at December 31, 2018 and 2017, 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 ($821 million and $321 million at December 31, 2018 and 2017, respectively) - These commingled funds have observable NAVs provided to investors and provide for liquidity either immediately or within a couple of days.


•	Real Estate ($147 million and $137 million at December 31, 2018 and 2017, 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 ($2 million and $103 million at December 31, 2018 and 2017, 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, 2016	$	148	$	64		$	212
Actual return on plan assets
Unrealized gains on assets still held at the reporting date	24		5			29
Purchases, sales and settlements, net	8		(3		)	5
Balance at December 31, 2017	180		66			246
Actual return on plan assets
Unrealized gains on assets still held at the reporting date	33		6			39
Purchases, sales and settlements, net	34		(3		)	31
Balance at December 31, 2018	$	247	$	69		$	316

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, 2018 and 2017 at a value of $442 million and $477 million, respectively.

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



	Fair Value Measurements at December 31, 2018
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.	$	—	$	47	$	—	$	47
Non-U.S.	—		61		—		61
Fixed income
Net cash equivalents ⁽¹⁾	12		—		—		12
Private equity, real estate and insurance ⁽²⁾	—		—		686		686
Net plan assets subject to leveling	$	12	$	108	$	686	$	806
Investments measured at net asset value							976
Net plan assets							$	1,782



	Fair Value Measurements at December 31, 2017
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.	$	—	$	63	$	—	$	63
Non-U.S.	—		91		—		91
Fixed income
Net cash equivalents ⁽¹⁾	29		—		—		29
Private equity, real estate and insurance ⁽²⁾	—		—		671		671
Net plan assets subject to leveling	$	29	$	154	$	671	$	854
Investments measured at net asset value							1,106
Net plan assets							$	1,960

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⁽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 ($753 million and $822 million at December 31, 2018 and 2017, 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. Equities ($100 million and $144 million at December 31, 2018 and 2017, respectively) - These commingled funds have observable NAVs provided to investors and provide for liquidity either immediately or within a couple of days.


•	Re-insurance ($77 million and $86 million at December 31, 2018 and 2017, respectively) - This commingled fund has a NAV that is determined on a monthly basis and the investment may be sold at that value.


•	Managed Futures Funds ($46 million and $54 million at December 31, 2018 and 2017, 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, 2016	$	439		$	57		$	117		$	613
Actual return on plan assets
Unrealized gains on assets still held at the reporting date	38			10			28			76
Purchases, sales and settlements, net	—			(8		)	(10		)	(18		)
Balance at December 31, 2017	477			59			135			671
Actual return on plan assets
Unrealized (losses) gains on assets still held at the reporting date	(35		)	(2		)	21			(16		)
Purchases, sales and settlements, net	—			—			31			31
Balance at December 31, 2018	$	442		$	57		$	187		$	686

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 $123 million to our defined benefit pension plans in 2019. The table below presents expected future benefit payments under our pension plans:



	Qualified and Non-Qualified Pension Plans
In millions	2019		2020		2021		2022		2023		2024 - 2028
Expected benefit payments	$	244	$	246	$	250	$	257	$	259	$	1,342

Other Pension Plans

We also sponsor defined contribution plans for certain hourly and salaried employees. Our contributions to these plans were $104 million, $84 million and $68 million for the years ended December 31, 2018, 2017 and 2016.