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, 2013

Compensation and Retirement Disclosure [Abstract]

PENSION AND OTHER POSTRETIREMENT BENEFITS

NOTE 12. 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	2013			2012			2013			2012
Change in benefit obligation
Benefit obligation at the beginning of the year	$	2,454		$	2,243		$	1,269		$	1,128
Service cost	70			58			21			21
Interest cost	93			103			57			59
Actuarial losses (gains)	(193		)	207			96			52
Benefits paid from fund	(150		)	(148		)	(50		)	(41		)
Benefits paid directly by employer	(13		)	(10		)	—			—
Exchange rate changes	—			—			37			52
Curtailment gain	—			—			—			(2		)
Other	—			1			(1		)	—
Benefit obligation at end of year	$	2,261		$	2,454		$	1,429		$	1,269

Change in plan assets
Fair value of plan assets at beginning of year	$	2,327		$	2,091		$	1,324		$	1,200
Actual return on plan assets	168			284			142			88
Employer contributions	100			100			56			22
Benefits paid	(150		)	(148		)	(50		)	(41		)
Exchange rate changes	—			—			44			55
Fair value of plan assets at end of year	$	2,445		$	2,327		$	1,516		$	1,324

Funded status (including underfunded and nonfunded plans) at end of year	$	184		$	(127	)	$	87		$	55

Amounts recognized in consolidated balance sheets
Prepaid pensions - long-term assets	$	427		$	127		$	87		$	55
Accrued compensation, benefits and retirement costs - current liabilities	(11		)	(10		)	—			—
Pensions - long-term liabilities	(232		)	(244		)	—			—
Net amount recognized	$	184		$	(127	)	$	87		$	55

Amounts recognized in accumulated other comprehensive loss consist of:
Net actuarial loss	$	478		$	734		$	361		$	349
Prior service credit	(1		)	(1		)	—			—
Net amount recognized	$	477		$	733		$	361		$	349

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 2 percent and 4 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	2013		2012		2013		2012
Total accumulated benefit obligation	$	2,231	$	2,417	$	1,309	$	1,167
Plans with accumulated benefit obligation in excess of plan assets
Accumulated benefit obligation	212		216		—		—
Plans with projected benefit obligation in excess of plan assets
Projected benefit obligation	243		254		—		—

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	2013			2012			2011			2013			2012			2011
Service cost	$	70		$	58		$	51		$	21		$	21		$	20
Interest cost	93			103			109			57			59			58
Expected return on plan assets	(167		)	(157		)	(151		)	(72		)	(81		)	(74		)
Amortization of prior service (credit) cost	(1		)	(1		)	(1		)	—			1			3
Recognized net actuarial loss	62			47			39			24			14			14
Net periodic pension cost	$	57		$	50		$	47		$	30		$	14		$	21

Other changes in benefit obligations and plan assets recognized in other comprehensive income in 2013, 2012 and 2011 were as follows:



In millions	2013			2012			2011
Amortization of prior service (cost) credit	$	1		$	(1	)	$	(2	)
Recognized actuarial loss	(86		)	(61		)	(53		)
Incurred prior service cost	—			1			1
Incurred actuarial (gain) loss	(168		)	124			138
Foreign exchange translation adjustments	10			16			—
Total recognized in other comprehensive income	$	(243	)	$	79		$	84

Total recognized in net periodic pension cost and other comprehensive income	$	(156	)	$	143		$	152

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 $57 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
	2013		2012		2013		2012
Discount rate	4.83	%	3.97	%	4.60	%	4.70	%
Compensation increase rate	4.91	%	4.90	%	4.50	%	4.00	%

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
	2013		2012		2011		2013		2012		2011
Discount rate	3.97	%	4.82	%	5.42	%	4.70	%	5.20	%	5.80	%
Expected return on plan assets	8.00	%	8.00	%	8.00	%	5.80	%	6.50	%	7.00	%
Compensation increase rate	4.91	%	4.00	%	4.00	%	4.00	%	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 8.0 percent in 2013. 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 use an assumption of 7.5 percent per year beginning in 2014.

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 2013. 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		Range
Global equities	30.5	%	+2.5/-5.0%
Real estate	7.5	%	+2.5/-5.0%
Re-insurance	5.0	%	+2.5/-5.0%
Private equity	7.5	%	+2.5/-5.0%
Corporate credit instruments	4.5	%	+2.5/-4.5%
Fixed income	45.0	%	+5.5/-2.0%
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 use our assumption of 5.8 percent per year beginning in 2014.

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, 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.	$	96	$	375	$	—	$	471
Non-U.S.	143		138		—		281
Fixed Income
Government debt	325		455		—		780
Corporate debt
U.S.	279		244		—		523
Non-U.S.	64		—		—		64
Asset/mortgaged backed securities	12		—		—		12
Net cash equivalents⁽¹⁾	36		—		—		36
Derivative instruments⁽²⁾	—		2		—		2
Private equity and real estate⁽³⁾	—		—		296		296
Total	$	955	$	1,214	$	296	$	2,465
Pending trade/purchases/sales							(28		)
Accruals⁽⁴⁾							8
Total							$	2,445



	Fair Value Measurements as of December 31, 2012
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.	$	113	$	542	$	—	$	655
Non-U.S.	177		127		—		304
Fixed Income
Government debt	475		132		—		607
Corporate debt
U.S.	203		191		—		394
Non-U.S.	42		—		—		42
Asset/mortgaged backed securities	13		—		—		13
Net cash equivalents⁽¹⁾	35		—		—		35
Private equity and real estate⁽³⁾	—		—		286		286
Total	$	1,058	$	992	$	286	$	2,336
Pending trade/purchases/sales							(16		)
Accruals⁽⁴⁾							7
Total							$	2,327

____________________________________________________


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


⁽²⁾	Derivative instruments include interest rate swaps, foreign currency forward contracts 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.

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, 2011	$	147		$	119	$	266
Actual return on plan assets
Unrealized (losses) gains on assets still held at the reporting date	15			9		24
Purchases, sales and settlements, net	(6		)	2		(4		)
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

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 at a value of $440 million at December 31, 2013 and $424 million at December 31, 2012.

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



	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⁽²⁾	—		24		—		24
Re-insurance	—		66		—		66
Private equity, real estate & insurance⁽³⁾	—		—		557		557
Total	$	13	$	946	$	557	$	1,516



	Fair Value Measurements as of December 31, 2012
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.	$	—	$	251	$	—	$	251
Non-U.S.	—		325		—		325
Fixed Income
Government debt	—		191		—		191
Net cash equivalents⁽¹⁾	10		—				10
Re-insurance	—		61		—		61
Private equity, real estate & insurance⁽³⁾	—		—		486		486
Total	$	10	$	828	$	486	$	1,324

_____________________________________________________


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


⁽²⁾	Derivative instruments include interest rate swaps, foreign currency forward contracts 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.

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, 2011	$	—		$	33	$	14	$	47
Actual return on plan assets
Unrealized (losses) gains on assets still held at the reporting date	13			1		1		15
Purchases, sales and settlements, net	411			—		13		424
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

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 $205 million to our defined benefit pension plans in 2014. The table below presents expected future benefit payments under our pension plans:



	Qualified and Non-Qualified Pension Plans
In millions	2014		2015		2016		2017		2018		2019 - 2023
Expected benefit payments	$	225	$	228	$	235	$	238	$	244	$	1,271

Other Pension Plans

We also sponsor defined contribution plans for certain hourly and salaried employees. Our contributions to these plans were $66 million, $74 million and $72 million for the years ended December 31, 2013, 2012 and 2011.

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	2013			2012
Change in benefit obligation
Benefit obligation at the beginning of the year	$	478		$	483
Interest cost	17			21
Plan participants' contributions	10			8
Plan amendments	—			(4		)
Actuarial losses (gains)	(49		)	21
Benefits paid directly by employer	(58		)	(51		)
Benefit obligation at end of year	$	398		$	478

Funded status at end of year	$	(398	)	$	(478	)

Amounts recognized in consolidated balance sheets
Accrued compensation, benefits and retirement costs - current liabilities	$	(42	)	$	(46	)
Postretirement benefits other than pensions-long-term liabilities	(356		)	(432		)
Net amount recognized	$	(398	)	$	(478	)

Amounts recognized in accumulated other comprehensive loss consist of:
Net actuarial loss	$	27		$	83
Prior service credit	(5		)	(6		)
Net amount recognized	$	22		$	77

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 5 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	2013		2012			2011
Interest cost	$	17	$	21		$	24
Amortization of prior service credit	—		(5		)	(8		)
Recognized net actuarial loss	6		3			—
Other	—		1			1
Net periodic other postretirement benefit cost	$	23	$	20		$	17

Other changes in benefit obligations recognized in other comprehensive income in 2013, 2012 and 2011 were as follows:



In millions	2013			2012			2011
Amortization of prior service credit	$	—		$	5		$	8
Recognized actuarial loss	(6		)	(3		)	—
Incurred actuarial (gain) loss	(49		)	20			16
Incurred prior service credit	—			(4		)	—
Other	—			(1		)	—
Total recognized in other comprehensive income	$	(55	)	$	17		$	24

Total recognized in net periodic other postretirement benefit cost and other comprehensive income	$	(32	)	$	37		$	41

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 zero.

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:



	2013		2012		2011
Discount rate	3.70	%	4.70	%	5.20	%

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 7.50 percent annual rate of increase in the per capita cost of covered health care benefits was assumed in 2013. 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 $19 million as of December 31, 2013 and the net periodic other postretirement benefit cost for 2014 by $1 million. A decrease in the health care cost trends of 1 percent would decrease our APBO by $16 million as of December 31, 2013 and the net periodic other postretirement benefit cost for 2014 by $1 million.

Estimated Benefit Payments

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



In millions	2014		2015		2016		2017		2018		2019 - 2023
Expected benefit payments	$	43	$	41	$	38	$	36	$	33	$	140