EMPLOYEE BENEFIT PLANS

PENSION BENEFIT PLANS

TEP has three noncontributory, defined benefit pension plans. Benefits are based on years of service and average compensation. Two of the plans cover the majority of TEP's employees. The Company funds those plans by contributing at least the minimum amount required under Internal Revenue Service (IRS) regulations. TEP also maintains a SERP for executive management.

OTHER POSTRETIREMENT BENEFIT PLAN

TEP provides limited health care and life insurance benefits for retirees. Active TEP employees may become eligible for these benefits if they reach retirement age while working for TEP or an affiliate.

TEP funds its other postretirement benefits for classified employees through a VEBA. TEP contributed $2 million in 2016, $4 million in 2015, and $3 million in 2014 to the VEBA. Other postretirement benefits for unclassified employees are self-funded.

REGULATORY RECOVERY

TEP records changes in non-SERP pension plans and the other postretirement defined benefit plan, not yet reflected in net periodic benefit cost, as a regulatory asset, as such amounts are probable of future recovery in the rates charged to retail customers. Changes in the SERP obligation, not yet reflected in net periodic benefit cost, are recorded in Other Comprehensive Income (Loss) since SERP expense is not currently recoverable in rates.

The following table summarizes pension and other postretirement benefit amounts (excluding tax balances) included in the Consolidated Balance Sheets:



	Pension Benefits						Other Postretirement Benefits
	December 31,
(in millions)	2016			2015			2016			2015
Regulatory Assets	$	123		$	115		$	5		$	5
Accrued Employee Expenses	(1		)	(1		)	(2		)	(2		)
Pension and Other Postretirement Benefits	(69		)	(57		)	(63		)	(63		)
Accumulated Other Comprehensive Loss, SERP	6			5			—			—
Net Amount Recognized	$	59		$	62		$	(60	)	$	(60	)

OBLIGATIONS AND FUNDED STATUS

The Company measured the actuarial present values of all defined benefit pension and other postretirement benefit obligations as of December 31, 2016 and 2015. The table below summarizes the status of all of TEP’s pension and other postretirement benefit plans. All plans have projected benefit obligations in excess of the fair value of plan assets for each period presented:



	Pension Benefits						Other Postretirement Benefits
	Years Ended December 31,
(in millions)	2016			2015			2016			2015
Change in Projected Benefit Obligation
Beginning of Period	$	394		$	407		$	78		$	81
Actuarial (Gain) Loss	20			(22		)	—			(5		)
Interest Cost	15			17			2			3
Service Cost	12			12			4			4
Benefits Paid	(17		)	(20		)	(5		)	(5		)
End of Period	424			394			79			78
Change in Fair Value of Plan Assets
Beginning of Period	336			335			13			12
Actual Return on Plan Assets	27			(3		)	1			—
Benefits Paid	(17		)	(20		)	(5		)	(5		)
Employer Contributions ⁽¹⁾	8			24			5			6
End of Period	354			336			14			13
Funded Status at End of Period	$	(70	)	$	(58	)	$	(65	)	$	(65	)


⁽¹⁾	TEP expects to contribute $11 million to the pension plans in 2017.

The following table provides the components of TEP’s regulatory assets and accumulated other comprehensive loss that have not been recognized as components of net periodic benefit cost as of the dates presented:



	Pension Benefits				Other Postretirement Benefits
	Years Ended December 31,
(in millions)	2016		2015		2016			2015
Net Loss	$	128	$	117	$	6		$	6
Prior Service Cost (Benefit)	—		3		(1		)	(1		)

The accumulated benefit obligation aggregated for all pension plans is $384 million and $355 million as of December 31, 2016 and 2015, respectively.

All three pension plans had accumulated benefit obligations in excess of plan assets as of December 31, 2016. Two of TEP's plans had accumulated benefit obligations in excess of plan assets as of December 31, 2015. The following table includes information for pension plans with accumulated benefit obligations in excess of pension plan assets:



	December 31,
(in millions)	2016		2015
Accumulated Benefit Obligation	$	384	$	188
Fair Value of Plan Assets	354		169

Net periodic benefit plan cost includes the following components:



	Pension Benefits									Other Postretirement Benefits
	Years Ended December 31,
(in millions)	2016			2015			2014			2016			2015			2014
Service Cost	$	12		$	12		$	10		$	4		$	4		$	4
Interest Cost	15			17			16			2			3			3
Expected Return on Plan Assets	(23		)	(23		)	(21		)	(1		)	(1		)	(1		)
Amortization of Net Loss	7			7			3			—			—			—
Net Periodic Benefit Cost	$	11		$	13		$	8		$	5		$	6		$	6

Approximately 19% of the net periodic benefit cost was capitalized as a cost of construction and the remainder was included in income.

Beginning in 2016, the Company elected to measure service and interest costs by applying the specific spot rates along the yield curve to the plans' liability cash flows. Prior to 2016, the Company measured service and interest costs for pension and other postretirement benefits utilizing a single weighted-average discount rate derived from the yield curve used to measure the plan obligations. TEP believes the new approach provides a more precise measurement of service and interest costs by aligning the timing of the plans' liability cash flows to the corresponding spot rates on the yield curve. This change does not affect the measurement of its plan obligations nor the funded status. TEP accounted for this change as a change in accounting estimate, and accordingly, accounted for it on a prospective basis.

The changes in plan assets and benefit obligations recognized as regulatory assets or in AOCI are as follows:



	Pension Benefits															Other Postretirement Benefits
	Regulatory Asset									AOCI						Regulatory Asset
(in millions)	2016			2015			2014			2016		2015		2014		2016		2015			2014
Current Year Actuarial (Gain) Loss	$	15		$	5		$	49		$	1	$	—	$	3	$	—	$	(4	)	$	5
Amortization of Net Loss	(7		)	(7		)	(3		)	—		—		—		—		—			—
Total Recognized (Gain) Loss	$	8		$	(2	)	$	46		$	1	$	—	$	3	$	—	$	(4	)	$	5

For all pension plans, TEP amortizes prior service costs on a straight-line basis over the average remaining service period of employees expected to receive benefits under the plan. Estimated amortization from regulatory assets into net periodic benefit cost in 2017 includes the following:



(in millions)	Pension Benefits		Other Postretirement Benefits
Net Loss	$	7	$	—

Net periodic benefit cost is subject to various assumptions and determinations, such as the discount rate, the rate of compensation increase, and the expected return on plan assets. Changes that may arise over time with regard to these assumptions and determinations will change amounts recorded in the future as net periodic benefit cost.

TEP uses a combination of sources in selecting the expected long-term rate-of-return-on-assets assumption, including an investment return model. The model used provides a “best-estimate” range over 20 years from the 25^th percentile to the 75^th percentile. The model, used as a guideline for selecting the overall rate-of-return-on-assets assumption, is based on forward-looking return expectations only. The above method is used for all asset classes.

The following table includes the weighted average assumptions used to determine benefit obligations:



	Pension Benefits		Other Postretirement Benefits
	2016	2015	2016	2015
Discount Rate	4.2%	4.5%	4.0%	4.2%
Rate of Compensation Increase	2.8%	3.0%	N/A	N/A

The following table includes the weighted average assumptions used to determine net periodic benefit costs:



	Pension Benefits			Other Postretirement Benefits
	2016	2015	2014	2016	2015	2014
Discount Rate, Service Cost	4.8%	4.2%	5.1%	4.6%	3.9%	4.7%
Discount Rate, Interest Cost	3.9%	4.2%	5.1%	3.4%	3.9%	4.7%
Rate of Compensation Increase	3.0%	3.0%	3.0%	N/A	N/A	N/A
Expected Return on Plan Assets	7.0%	7.0%	7.0%	7.0%	7.0%	7.0%

The following table includes the assumed health care cost trend rates:



	December 31,
	2016	2015
Next Year	7.6%	7.6%
Ultimate Rate Assumed	4.5%	4.5%
Year Ultimate Rate is Reached	2037	2036

Assumed health care cost trend rates significantly affect the amounts reported for health care plans. A one-percentage-point change in assumed health care cost trend rates would have the following effects on the amounts:



	One-Percentage- Point Increase		One-Percentage- Point Decrease
(in millions)	December 31, 2016
Increase (Decrease) on Total Service and Interest Cost Components	$	1	$	(1	)
Increase (Decrease) on Other Postretirement Benefit Obligation	7		(6		)

PENSION PLAN AND OTHER POSTRETIREMENT BENEFIT ASSETS

TEP calculates the fair value of plan assets on December 31, the measurement date. Asset allocations, by asset category, on the measurement date were as follows:



	Pension				Other Postretirement
	2016		2015		2016		2015
Asset Category
Equity Securities	49	%	49	%	60	%	60	%
Fixed Income Securities	41	%	41	%	35	%	35	%
Real Estate	8	%	8	%	2	%	2	%
Other	2	%	2	%	3	%	3	%
Total	100	%	100	%	100	%	100	%

As of December 31, 2016, the fair value of VEBA trust assets was $14 million, of which $5 million were fixed income investments and $9 million were equities. As of December 31, 2015, the fair value of VEBA trust assets was $13 million, of which $5 million were fixed income investments and $8 million were equities. The VEBA trust assets are primarily Level 2. There are no Level 3 assets in the VEBA trust.

The following table sets forth the fair value measurements of pension plan assets by level within the fair value hierarchy:



	Level 1		Level 2		Level 3		Total
(in millions)	December 31, 2016
Asset Category
Cash Equivalents	$	1	$	—	$	—	$	1
Equity Securities:
United States Large Cap	—		61		—		61
United States Small Cap	—		18		—		18
Non-United States	—		67		—		67
Global	—		28		—		28
Fixed Income	—		144		—		144
Real Estate	—		9		19		28
Private Equity	—		—		7		7
Total	$	1	$	327	$	26	$	354

(in millions)	December 31, 2015
Asset Category
Cash Equivalents	$	1	$	—	$	—	$	1
Equity Securities:
United States Large Cap	—		81		—		81
United States Small Cap	—		17		—		17
Non-United States	—		67		—		67
Fixed Income	—		137		—		137
Real Estate	—		8		18		26
Private Equity	—		—		7		7
Total	$	1	$	310	$	25	$	336


•	Level 1 cash equivalents are based on observable market prices and are comprised of the fair value of commercial paper, money market funds, and certificates of deposit.


•	Level 2 investments comprise amounts held in commingled equity funds, United States bond funds, and real estate funds. Valuations are based on active market quoted prices for assets held by each respective fund.


•	Level 3 real estate investments were valued using a real estate index value. The real estate index value was developed based on appraisals comprising 100% of real estate assets tracked by the index.


•	Level 3 private equity funds are classified as funds-of-funds. They are valued based on individual fund manager valuation models.

The following table sets forth a reconciliation of changes in the fair value of pension assets classified as Level 3 in the fair value hierarchy. There were no transfers in or out of Level 3.



(in millions)	Private Equity			Real Estate		Total
Balance as of December 31, 2014	$	7		$	16	$	23
Actual Return on Plan Assets:
Assets Held at Reporting Date	1			2		3
Purchases, Sales, and Settlements	(1		)	—		(1		)
Balance as of December 31, 2015	7			18		25
Actual Return on Plan Assets:
Assets Held at Reporting Date	1			1		2
Purchases, Sales, and Settlements	(1		)	—		(1		)
Balance as of December 31, 2016	$	7		$	19	$	26

Pension Plan Investments

Investment Goals

Asset allocation is the principal method for achieving each pension plan’s investment objectives while maintaining appropriate levels of risk. TEP considers the projected impact on benefit security of any proposed changes to the current asset allocation policy. The expected long-term returns and implications for pension plan sponsor funding are reviewed in selecting policies to ensure that current asset pools are projected to be adequate to meet the expected liabilities of the pension plans. TEP expects to use asset allocation policies weighted most heavily to equity and fixed income funds, while maintaining some exposure to real estate and opportunistic funds. Within the fixed income allocation, long-duration funds may be used to partially hedge interest rate risk.

Risk Management

TEP recognizes the difficulty of achieving investment objectives in light of the uncertainties and complexities of the investment markets. The Company recognizes some risk must be assumed to achieve a pension plan’s long-term investment objectives. In establishing risk tolerances, the following factors affecting risk tolerance and risk objectives will be considered: plan status, plan sponsor financial status and profitability, plan features, and workforce characteristics. TEP determined that the pension plans can tolerate some interim fluctuations in market value and rates of return in order to achieve long-term objectives. TEP tracks each pension plan’s portfolio relative to the benchmark through quarterly investment reviews. The reviews consist of a performance and risk assessment of all investment categories and on the portfolio as a whole. Investment managers for the pension plan may use derivative financial instruments for risk management purposes or as part of their investment strategy. Currency hedges may also be used for defensive purposes.

Relationship between Plan Assets and Benefit Obligations

The overall health of each plan will be monitored by comparing the value of plan obligations (both Accumulated Benefit Obligation and Projected Benefit Obligation) against the fair value of assets and tracking the changes in each. The frequency of this monitoring will depend on the availability of plan data, but will be no less frequent than annually via actuarial valuation.

Target Allocation Percentages

The current target allocation percentages for the major asset categories of the plan follow. Each plan allows a variance of +/- 2% from targets before funds are automatically rebalanced.



	Pension	Other Postretirement
	December 31, 2016
Cash/Treasury Bills	—%	2%
Equity Securities:
United States Large Cap	17%	39%
United States Small Cap	5%	5%
Non-United States Developed	15%	7%
Non-United States Emerging	4%	9%
Global Equity	5%	—%
Global Infrastructure	3%	—%
Fixed Income	42%	38%
Real Estate	8%	—%
Private Equity	1%	—%
Total	100%	100%

Pension Fund Descriptions

For each type of asset category selected by the Pension Committee, TEP's investment consultant assembles a group of third-party fund managers and allocates a portion of the total investment to each fund manager. In the case of the private equity fund, TEP's investment consultant directs investments to a private equity manager that invests in third-parties’ funds.

ESTIMATED FUTURE BENEFIT PAYMENTS

TEP expects the following benefit payments to be made by the defined benefit pension plans and other postretirement benefit plan, which reflect future service, as appropriate.



(in millions)	2017		2018		2019		2020		2021		2022-2026
Pension Benefits	$	18	$	19	$	20	$	22	$	23	$	128
Other Postretirement Benefits	4		5		5		6		6		32

DEFINED CONTRIBUTION PLAN

TEP offers a defined contribution savings plan to all eligible employees. The Internal Revenue Code identifies the plan as a qualified 401(k) plan. Participants direct the investment of contributions to certain funds in their account. The Company matches part of a participant’s contributions to the plan. TEP made matching contributions to the plan of $5 million in 2016, 2015, and 2014.