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

Discount rate

PENSION AND OTHER POSTRETIREMENT BENEFITS

12 Months Ended

Dec. 31, 2014

Compensation and Retirement Disclosure [Abstract]

PENSION AND OTHER POSTRETIREMENT BENEFITS

NOTE 11. 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 were as follows:



	Qualified and Non-Qualified Pension Plans
	U.S. Plans						U.K. Plans
In millions	2014			2013			2014			2013
Change in benefit obligation
Benefit obligation at the beginning of the year	$	2,261		$	2,454		$	1,429		$	1,269
Service cost	66			70			24			21
Interest cost	105			93			63			57
Actuarial loss (gain)	301			(193		)	139			96
Benefits paid from fund	(143		)	(150		)	(48		)	(50		)
Benefits paid directly by employer	(11		)	(13		)	—			—
Exchange rate changes	—			—			(85		)	37
Other	—			—			—			(1		)
Benefit obligation at end of year	$	2,579		$	2,261		$	1,522		$	1,429
Change in plan assets
Fair value of plan assets at beginning of year	$	2,445		$	2,327		$	1,516		$	1,324
Actual return on plan assets	311			168			254			142
Employer contributions	100			100			94			56
Benefits paid	(143		)	(150		)	(48		)	(50		)
Exchange rate changes	—			—			(92		)	44
Fair value of plan assets at end of year	$	2,713		$	2,445		$	1,724		$	1,516
Funded status (including underfunded and nonfunded plans) at end of year	$	134		$	184		$	202		$	87
Amounts recognized in consolidated balance sheets
Prepaid pensions - long-term assets	$	435		$	427		$	202		$	87
Accrued compensation, benefits and retirement costs - current liabilities	(12		)	(11		)	—			—
Pensions - long-term liabilities	(289		)	(232		)	—			—
Net amount recognized	$	134		$	184		$	202		$	87
Amounts recognized in accumulated other comprehensive loss consist of:
Net actuarial loss	$	611		$	478		$	286		$	361
Prior service credit	(1		)	(1		)	—			—
Net amount recognized	$	610		$	477		$	286		$	361

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 5 percent of our pension plan assets and obligations, respectively. These plans are reflected in "Other liabilities and deferred revenue" on our Consolidated Balance Sheets.

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	2014		2013		2014		2013
Total accumulated benefit obligation	$	2,539	$	2,231	$	1,402	$	1,309
Plans with accumulated benefit obligation in excess of plan assets
Accumulated benefit obligation	261		212		—		—
Plans with projected benefit obligation in excess of plan assets
Projected benefit obligation	301		243		—		—

Components of Net Periodic Pension Cost

The following table presents the net periodic pension cost under our plans:



	Qualified and Non-Qualified Pension Plans
	U.S. Plans									U.K. Plans
In millions	2014			2013			2012			2014			2013			2012
Service cost	$	66		$	70		$	58		$	24		$	21		$	21
Interest cost	105			93			103			63			57			59
Expected return on plan assets	(173		)	(167		)	(157		)	(84		)	(72		)	(81		)
Amortization of prior service (credit) cost	(1		)	(1		)	(1		)	—			—			1
Recognized net actuarial loss	31			62			47			26			24			14
Net periodic pension cost	$	28		$	57		$	50		$	29		$	30		$	14

Other changes in benefit obligations and plan assets recognized in other comprehensive income in 2014, 2013 and 2012 were as follows:



In millions	2014			2013			2012
Amortization of prior service (cost) credit	$	1		$	1		$	(1	)
Recognized actuarial loss	(57		)	(86		)	(61		)
Incurred prior service cost	—			—			1
Incurred actuarial (gain) loss	133			(168		)	124
Foreign exchange translation adjustments	(18		)	10			16
Total recognized in other comprehensive income	$	59		$	(243	)	$	79

Total recognized in net periodic pension cost and other comprehensive income	$	116		$	(156	)	$	143

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 $71 million.

Assumptions

The table below presents various assumptions used in determining the pension benefit obligation 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
	2014		2013		2014		2013
Discount rate	4.07	%	4.83	%	3.80	%	4.60	%
Compensation increase rate	4.88	%	4.91	%	4.25	%	4.50	%

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
	2014		2013		2012		2014		2013		2012
Discount rate	4.83	%	3.97	%	4.82	%	4.60	%	4.70	%	5.20	%
Expected return on plan assets	7.50	%	8.00	%	8.00	%	5.80	%	5.80	%	6.50	%
Compensation increase rate	4.91	%	4.91	%	4.00	%	4.50	%	4.00	%	4.25	%

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 2014. 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, we have elected to continue using our assumption of 7.5 percent in 2015.

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	9.0	%	+/-5.0%
Non-U.S. equities	3.0	%	+/-3.0%
Global equities	10.0	%	+/-3.0%
Total equities	22.0	%
Real estate	7.0	%	+3.0/-7.0%
Private equity	7.0	%	+3.0/-7.0%
Fixed income	64.0	%	+/-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 95 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 64 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 5.8 percent in 2014. 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 (equities and real estate) and liability matching assets (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	25.5	%
Real estate	7.5	%
Re-insurance	5.0	%
Private equity	7.5	%
Corporate credit instruments	4.5	%
Fixed income	50.0	%
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 to continue using our assumption of 5.8 percent in 2015.

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 as of December 31, 2014
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.	$	103	$	297	$	—	$	400
Non-U.S.	137		82		—		219
Fixed Income
Government debt	—		886		—		886
Corporate debt
U.S.	—		724		—		724
Non-U.S.	—		87		—		87
Asset/mortgaged backed securities	—		45		—		45
Net cash equivalents⁽¹⁾	28		2		—		30
Derivative instruments⁽²⁾	—		2		—		2
Private equity and real estate⁽³⁾	—		—		306		306
Total	$	268	$	2,125	$	306	$	2,699
Pending trade/purchases/sales							5
Accruals⁽⁴⁾							9
Total							$	2,713



	Fair Value Measurements as of December 31, 2013
In millions	Quoted prices in active markets for identical assets (Level 1) ⁽⁵⁾		Significant other observable inputs (Level 2) ⁽⁵⁾		Significant unobservable inputs (Level 3)		Total
Equities
U.S.	$	96	$	387	$	—	$	483
Non-U.S.	143		126		—		269
Fixed Income
Government debt	—		780		—		780
Corporate debt
U.S.	—		523		—		523
Non-U.S.	—		64		—		64
Asset/mortgaged backed securities	—		12		—		12
Net cash equivalents⁽¹⁾	33		3		—		36
Derivative instruments⁽²⁾	—		2		—		2
Private equity and real estate ⁽³⁾	—		—		296		296
Total	$	272	$	1,897	$	296	$	2,465
Pending trade/purchases/sales							(28		)
Accruals⁽⁴⁾							8
Total							$	2,445

____________________________________________________


⁽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 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⁾	Interest or dividends that had not been settled as of the year ended December 31.


⁽⁵⁾	We revised 2013 balances to classify $683 million as Level 2 assets instead of Level 1.

The reconciliation of Level 3 assets was as follows:



	Fair Value Measurements as of December 31, Using Significant Unobservable Inputs (Level 3)
In millions	Private Equity			Real Estate		Total
Balance at December 31, 2012	$	156		$	130	$	286
Actual return on plan assets
Unrealized (losses) gains on assets still held at the reporting date	20			10		30
Purchases, sales and settlements, net	(23		)	3		(20		)
Balance at December 31, 2013	153			143		296
Actual return on plan assets
Unrealized (losses) gains on assets still held at the reporting date	22			11		33
Purchases, sales and settlements, net	(27		)	4		(23		)
Balance at December 31, 2014	$	148		$	158	$	306

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. This is included in the table below in Level 3 for years ended December 31, 2014 and 2013 at a value of $462 million and $440 million, respectively.

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



	Fair Value Measurements as of December 31, 2014
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.	$	—	$	153	$	—	$	153
Non-U.S.	—		399		—		399
Fixed Income
Corporate debt
U.S.	—		321		—		321
Non-U.S.	—		158		—		158
Net cash equivalents⁽¹⁾	24		—		—		24
Re-insurance	—		65		—		65
Private equity, real estate & insurance⁽²⁾	—		—		604		604
Total	$	24	$	1,096	$	604	$	1,724



	Fair Value Measurements as of December 31, 2013
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.	$	—	$	270	$	—	$	270
Non-U.S.	—		328		—		328
Fixed Income
Government debt	—		120		—		120
Corporate debt non-U.S.	—		138		—		138
Net cash equivalents⁽¹⁾	13		—		—		13
Derivative instruments⁽³⁾	—		24		—		24
Re-insurance	—		66		—		66
Private equity, real estate & insurance⁽²⁾	—		—		557		557
Total	$	13	$	946	$	557	$	1,516

_____________________________________________________


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


⁽²⁾	The instruments in private equity 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 audited financial statement of the funds.


⁽³⁾	Derivative instruments consist of interest rate swaps.

The reconciliation of Level 3 assets was as follows:



	Fair Value Measurements as of December 31, Using Significant Unobservable Inputs (Level 3)
In millions	Insurance			Real Estate			Private Equity		Total
Balance at December 31, 2012	$	424		$	34		$	28	$	486
Actual return on plan assets
Unrealized (losses) gains on assets still held at the reporting date	29			2			5		36
Purchases, sales and settlements, net	(13		)	33			15		35
Balance at December 31, 2013	440			69			48		557
Actual return on plan assets
Unrealized (losses) gains on assets still held at the reporting date	42			(3		)	11		50
Purchases, sales and settlements, net	(20		)	(5		)	22		(3		)
Balance at December 31, 2014	$	462		$	61		$	81	$	604

Level 3 Assets

The investments in an insurance contract, private equity 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 $175 million to our defined benefit pension plans in 2015. The table below presents expected future benefit payments under our pension plans:



	Qualified and Non-Qualified Pension Plans
In millions	2015		2016		2017		2018		2019		2020 - 2024
Expected benefit payments	$	231	$	232	$	238	$	243	$	247	$	1,283

Other Pension Plans

We also sponsor defined contribution plans for certain hourly and salaried employees. Our contributions to these plans were $73 million, $66 million and $74 million for the years ended December 31, 2014, 2013 and 2012.

Other Postretirement Benefits

Our other postretirement benefit plans provide various health care and life insurance benefits to eligible employees, who retire and satisfy certain age and service requirements, and their dependents. The plans are contributory and contain cost-sharing features such as caps, deductibles, coinsurance and spousal contributions. Employer contributions are limited by formulas in each plan. Retiree contributions for health care benefits are adjusted annually and we reserve the right to change benefits covered under these plans. There were no plan assets for the postretirement benefit plans as our policy is to fund benefits and expenses for these plans as claims and premiums are incurred.

Obligations and Funded Status

Benefit obligation balances presented below reflect the accumulated postretirement benefit obligations (APBO) for our other postretirement benefit plans. The changes in the benefit obligations, the funded status of the plans and the amounts recognized in our Consolidated Balance Sheets for our significant other postretirement benefit plans were as follows:



In millions	2014			2013
Change in benefit obligation
Benefit obligation at the beginning of the year	$	398		$	478
Interest cost	17			17
Plan participants' contributions	10			10
Actuarial loss (gain)	38			(49		)
Benefits paid directly by employer	(55		)	(58		)
Benefit obligation at end of year	$	408		$	398

Funded status at end of year	$	(408	)	$	(398	)

Amounts recognized in consolidated balance sheets
Accrued compensation, benefits and retirement costs - current liabilities	$	(39	)	$	(42	)
Postretirement benefits other than pensions-long-term liabilities	(369		)	(356		)
Net amount recognized	$	(408	)	$	(398	)

Amounts recognized in accumulated other comprehensive loss consist of:
Net actuarial loss	$	65		$	27
Prior service credit	(5		)	(5		)
Net amount recognized	$	60		$	22

In addition to the other postretirement plans in the above table, we also maintain less significant postretirement plans in four other countries outside the U.S. that comprise less than 7 percent of our postretirement obligations. These plans are reflected in "Other liabilities and deferred revenue" in our Consolidated Balance Sheets.

Components of Net Periodic Other Postretirement Benefits Cost

The following table presents the net periodic other postretirement benefits cost under our plans:



In millions	2014		2013		2012
Interest cost	$	17	$	17	$	21
Amortization of prior service credit	—		—		(5		)
Recognized net actuarial loss	—		6		3
Other	—		—		1
Net periodic other postretirement benefit cost	$	17	$	23	$	20

Other changes in benefit obligations recognized in other comprehensive income in 2014, 2013 and 2012 were as follows:



In millions	2014		2013			2012
Amortization of prior service credit	$	—	$	—		$	5
Recognized actuarial loss	—		(6		)	(3		)
Incurred actuarial (gain) loss	38		(49		)	20
Incurred prior service credit	—		—			(4		)
Other	—		—			(1		)
Total recognized in other comprehensive income	$	38	$	(55	)	$	17

Total recognized in net periodic other postretirement benefit cost and other comprehensive income	$	55	$	(32	)	$	37

The amount in accumulated other comprehensive loss expected to be recognized as a component of net periodic other postretirement benefit cost during the next fiscal year is $5 million.

Assumptions

The table below presents assumptions used in determining the other postretirement benefit obligation for each year and reflects weighted-average percentages for our other postretirement plans as follows:

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



	2014		2013		2012
Discount rate	4.55	%	3.70	%	4.70	%

Our consolidated other postretirement benefit obligation is determined by application of the terms of health care and life insurance plans, together with relevant actuarial assumptions and health care cost trend rates. For measurement purposes, a 7.00 percent annual rate of increase in the per capita cost of covered health care benefits was assumed in 2014. The rate is assumed to decrease on a linear basis to 5.00 percent through 2019 and remain at that level thereafter. An increase in the health care cost trends of 1 percent would increase our APBO by $22 million as of December 31, 2014 and the net periodic other postretirement benefit cost for 2015 by $1 million. A decrease in the health care cost trends of 1 percent would decrease our APBO by $18 million as of December 31, 2014 and the net periodic other postretirement benefit cost for 2015 by $1 million.

Estimated Benefit Payments

The table below presents expected benefit payments under our other postretirement benefit plans:



In millions	2015		2016		2017		2018		2019		2020 - 2024
Expected benefit payments	$	40	$	38	$	36	$	33	$	31	$	134

- Definition

The entire disclosure for pension and other postretirement benefits.

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