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 BENEFITS PLAN

TEP provides limited healthcare 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 $3 million in 2017, $2 million in 2016, and $4 million in 2015 to the VEBA. Other postretirement benefits for unclassified employees are self-funded.

REGULATORY RECOVERY

TEP records changes in non-SERP pension and other postretirement defined benefit plans, 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 since SERP expense is not currently recoverable in rates.

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



	Pension Benefits						Other Postretirement Benefits
	December 31,
(in millions)	2017			2016			2017			2016
Regulatory Assets	$	121		$	123		$	5		$	5
Accrued Employee Expenses	(1		)	(1		)	(2		)	(2		)
Pension and Other Postretirement Benefits	(71		)	(69		)	(63		)	(63		)
Accumulated Other Comprehensive Loss, SERP	9			6			—			—
Net Amount Recognized	$	58		$	59		$	(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, 2017 and 2016. The table below presents 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)	2017			2016			2017			2016
Change in Benefit Obligation
Beginning of Period	$	424		$	394		$	79		$	78
Actuarial Loss	42			20			1			—
Interest Cost	15			15			2			2
Service Cost	13			12			4			4
Benefits Paid	(19		)	(17		)	(4		)	(5		)
End of Period	475			424			82			79
Change in Fair Value of Plan Assets
Beginning of Period	354			336			14			13
Actual Return on Plan Assets	59			27			2			1
Benefits Paid	(19		)	(17		)	(4		)	(5		)
Employer Contributions ⁽¹⁾	9			8			5			5
End of Period	403			354			17			14
Funded Status at End of Period	$	(72	)	$	(70	)	$	(65	)	$	(65	)


⁽¹⁾	TEP expects to contribute $11 million to the pension plans in 2018.

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)	2017		2016		2017			2016
Net Loss	$	129	$	128	$	5		$	6
Prior Service Cost (Benefit)	1		—		(1		)	(1		)

The accumulated benefit obligation aggregated for all pension plans is $428 million and $384 million as of December 31, 2017 and 2016, respectively. Two of the pension plans had accumulated benefit obligations in excess of plan assets as of December 31, 2017, compared to three as of December 31, 2016, as a result of market gains on plan assets in 2017. The following table includes information for the pension plans with accumulated benefit obligations in excess of pension plan assets:



	December 31,
(in millions)	2017		2016
Accumulated Benefit Obligation	$	237	$	384
Fair Value of Plan Assets	206		354

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. Net periodic benefit plan cost includes the following components:



	Pension Benefits									Other Postretirement Benefits
	Years Ended December 31,
(in millions)	2017			2016			2015			2017			2016			2015
Service Cost	$	13		$	12		$	12		$	4		$	4		$	4
Interest Cost	15			15			17			2			2			3
Expected Return on Plan Assets	(25		)	(23		)	(23		)	(1		)	(1		)	(1		)
Amortization of Net Loss	8			7			7			—			—			—
Net Periodic Benefit Cost	$	11		$	11		$	13		$	5		$	5		$	6

Approximately 18% of the net periodic benefit cost was capitalized as a cost of construction and the remainder was included in income.

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



	Pension Benefits															Other Postretirement Benefits
	Regulatory Asset									AOCI						Regulatory Asset
(in millions)	2017			2016			2015			2017		2016		2015		2017			2016		2015
Current Year Actuarial (Gain) Loss	$	5		$	15		$	5		$	3	$	1	$	—	$	(1	)	$	—	$	(4	)
Amortization of Net Loss	(7		)	(7		)	(7		)	—		—		—		—			—		—
Total Recognized (Gain) Loss	$	(2	)	$	8		$	(2	)	$	3	$	1	$	—	$	(1	)	$	—	$	(4	)

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 plans. Estimated amortization from regulatory assets into net periodic benefit cost in 2018 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
	2017	2016	2017	2016
Discount Rate	3.7%	4.2%	3.6%	4.0%
Rate of Compensation Increase	2.8%	2.8%	N/A	N/A

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



	Pension Benefits			Other Postretirement Benefits
	2017	2016	2015	2017	2016	2015
Discount Rate, Service Cost	4.4%	4.8%	4.2%	4.3%	4.6%	3.9%
Discount Rate, Interest Cost	3.7%	3.9%	4.2%	3.3%	3.4%	3.9%
Rate of Compensation Increase	2.8%	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%

Healthcare cost trend rates are assumed to decrease gradually from next year to the year the ultimate rate is reached:



	December 31,
	2017	2016
Next Year	7.6%	7.6%
Ultimate Rate Assumed	4.5%	4.5%
Year Ultimate Rate is Reached	2036	2037

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



	One-Percentage- Point Increase		One-Percentage- Point Decrease
(in millions)	December 31, 2017
Increase (Decrease) on Total Service and Interest Cost Components	$	1	$	(1	)
Increase (Decrease) on Other Postretirement Benefits 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 Benefits
	2017		2016		2017		2016
Asset Category
Equity Securities	46	%	49	%	63	%	60	%
Fixed Income Securities	45	%	41	%	35	%	35	%
Real Estate	7	%	8	%	—	%	2	%
Other	2	%	2	%	2	%	3	%
Total	100	%	100	%	100	%	100	%

As of December 31, 2017, the fair value of VEBA trust assets was $17 million, of which $6 million were fixed income investments and $11 million were equities. 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. The VEBA trust assets are primarily Level 2. There are no Level 3 assets in the VEBA trust.

The following tables present 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, 2017
Asset Category
Cash Equivalents	$	1	$	—	$	—	$	1
Equity Securities:
United States Large Cap	—		66		—		66
United States Small Cap	—		19		—		19
Non-United States	—		72		—		72
Global	—		30		—		30
Fixed Income	—		179		—		179
Real Estate	—		9		21		30
Private Equity	—		—		6		6
Total	$	1	$	375	$	27	$	403

(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


•	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 values are generally determined by appraisals conducted in accordance with accepted appraisal guidelines, including consideration of projected income and expenses of the property as well as recent sales of similar properties.


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

The following table presents a reconciliation of changes in the fair value of pension plan 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, 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
Actual Return on Plan Assets:
Assets Held at Reporting Date	1			2		3
Purchases, Sales, and Settlements	(2		)	—		(2		)
Balance as of December 31, 2017	$	6		$	21	$	27

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: (i) plan status; (ii) plan sponsor financial status and profitability; (iii) plan features; and (iv) 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 Benefits
	December 31, 2017
Cash/Treasury Bills	—%	2%
Equity Securities:
United States Large Cap	16%	39%
United States Small Cap	5%	5%
Non-United States Developed	14%	7%
Non-United States Emerging	4%	9%
Global Equity	4%	—%
Global Infrastructure	3%	—%
Fixed Income	45%	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 plans, which reflect future service, as appropriate.



(in millions)	2018		2019		2020		2021		2022		2023-2027
Pension Benefits	$	21	$	22	$	23	$	24	$	25	$	137
Other Postretirement Benefits	5		5		5		6		6		30

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 $6 million in 2017, and $5 million in both 2016 and 2015.