Note 11 - Employee Benefit Plans

Retirement Plans

Profit Sharing Plans. The profit-sharing plan is a defined contribution retirement plan that covers employees who have completed at least one year of service and are age 21 or older. All contributions to the plan are made at the discretion of the Corporation and may be made without regard to current or accumulated profits. Contributions are allocated to eligible participants pro rata, based upon compensation, age and other factors. Plan participants self-direct the investment of allocated contributions by choosing from a menu of investment options. Account assets are subject to withdrawal restrictions and participants vest in their accounts after three years of service. The Corporation also maintains a separate non-qualified profit sharing plan for certain employees whose participation in the qualified profit sharing plan is limited. The plan offers such employees an alternative means of receiving comparable benefits. Expense related to these plans totaled $9.2 million in 2012, $11.8 million in 2011 and $12.0 million in 2010.

Retirement Plan and Restoration Plan. The Corporation maintains a non-contributory defined benefit plan (the “Retirement Plan”) that was frozen as of December 31, 2001. The plan provides pension and death benefits to substantially all employees who were at least 21 years of age and had completed at least one year of service prior to December 31, 2001. Defined benefits are provided based on an employee’s final average compensation and years of service at the time the plan was frozen and age at retirement. The freezing of the plan provides that future salary increases will not be considered. The Corporation’s funding policy is to contribute yearly, at least the amount necessary to satisfy the funding standards of the Employee Retirement Income Security Act (“ERISA”).

The Corporation’s Restoration of Retirement Income Plan (the “Restoration Plan”) provides benefits for eligible employees that are in excess of the limits under Section 415 of the Internal Revenue Code of 1986, as amended, that apply to the Retirement Plan. The Restoration Plan is designed to comply with the requirements of ERISA. The entire cost of the plan, which was also frozen as of December 31, 2001, is supported by contributions from the Corporation.

The Corporation uses a December 31 measurement date for its defined benefit plans. Combined activity in the Corporation’s defined benefit pension plans was as follows:


	2012			2011			2010

Change in benefit obligation:
Benefit obligation at beginning of year	$	157,855		$	145,246		$	132,456
Interest cost		7,801			7,892			7,724
Actuarial (gain) loss		18,436			10,383			10,189
Benefits paid		(5,934	)		(5,666	)		(5,123	)

Benefit obligation at end of year		178,158			157,855			145,246

Change in plan assets:
Fair value of plan assets at beginning of year		137,253			141,050			128,044
Actual return on plan assets		13,931			(3,776	)		17,580
Employer contributions		651			5,645			549
Benefits paid		(5,934	)		(5,666	)		(5,123	)

Fair value of plan assets at end of year		145,901			137,253			141,050

Funded status of the plan at end of year and accrued benefit liability recognized	$	32,257		$	20,602		$	4,196

Accumulated benefit obligation at end of year	$	178,158		$	157,855		$	145,246

Certain disaggregated information related to the Corporation’s defined benefit pension plans as of year-end was as follows:


	Retirement Plan				Restoration Plan

	2012		2011		2012		2011

Projected benefit obligation	$	160,738	$	141,277	$	17,420	$	16,578
Accumulated benefit obligation		160,738		141,277		17,420		16,578
Fair value of plan assets		145,901		137,253		-		-
Funded status of the plan at end of year and accrued benefit (asset) liability recognized		14,837		4,024		17,420		16,578

The components of the combined net periodic benefit cost (benefit) for the Corporation’s defined benefit pension plans were as follows:


	2012			2011			2010

Expected return on plan assets, net of expenses	$	(10,412	)	$	(11,434	)	$	(11,008	)
Interest cost on projected benefit obligation		7,801			7,892			7,724
Net amortization and deferral		5,709			3,130			2,915

Net periodic cost (benefit)	$	3,098		$	(412	)	$	(369	)

Amounts related to the Corporation’s defined benefit pension plans recognized as a component of other comprehensive income were as follows:


	2012			2011			2010

Net actuarial gain (loss)	$	(9,405	)	$	(22,463	)	$	(702	)
Deferred tax (expense) benefit		3,292			7,862			245

Other comprehensive income (loss), net of tax	$	(6,113	)	$	(14,601	)	$	(457	)

Amounts recognized as a component of accumulated other comprehensive loss as of year-end that have not been recognized as a component of the combined net period benefit cost of the Corporation’s defined benefit pension plans are presented in the following table. The Corporation expects to recognize approximately $6.6 million of the net actuarial loss reported in the following table as of December 31, 2012 as a component of net periodic benefit cost during 2013.


	2012			2011

Net actuarial loss	$	(75,494	)	$	(66,287	)
Deferred tax benefit		26,423			23,200

Amounts included in accumulated other comprehensive loss, net of tax	$	(49,071	)	$	(43,087	)

The weighted-average assumptions used to determine the benefit obligations as of the end of the years indicated and the net periodic benefit cost for the years indicated are presented in the table below. Because the plans were frozen, increases in compensation are not considered after 2001.


	2012			2011			2010

Benefit obligations:
Discount rate		4.20	%		5.05	%		5.55	%
Net periodic benefit cost:
Discount rate		5.05	%		5.55	%		5.95	%
Expected return on plan assets		7.75			8.25			8.75

Management uses an asset allocation optimization model to analyze the potential risks and rewards associated with various asset allocation strategies on a quarterly basis. As of December 31, 2012, management’s investment objective for the Corporation’s defined benefit plans is to achieve long-term growth. This strategy provides for a target asset allocation of approximately 62% invested in equity securities, approximately 35% invested in fixed income debt securities with any remainder invested in cash or short-term cash equivalents. The modeling process calculates, with a 90% confidence ratio, the potential risk associated with a given asset allocation and helps achieve adequate diversification of investment assets. The plan assets are reviewed annually to determine if the obligations can be met with the current investment mix and funding strategy.

The major categories of assets in the Corporation’s Retirement Plan as of year-end is presented in the following table. Assets are segregated by the level of the valuation inputs within the fair value hierarchy established by ASC Topic 820 “Fair Value Measurements and Disclosures,” utilized to measure fair value (see Note 16 - Fair Value Measurements). The Plan previously reported certain investments using Level 1 market inputs. Plan management has determined that certain of these investments should have been reported as Level 2. This change had no impact on the fair value of the investments in any of the periods presented. The Corporation’s Restoration Plan is unfunded.


	2012		2011

Level 1:
Mutual funds	$	141,115	$	127,022
Cash and cash equivalents		2,466		7,091

Level 2:
Corporate bonds and notes		1,350		1,973
U.S. government agency securities		696		896
States and political subdivisions		274		271

Total fair value of plan assets	$	145,901	$	137,253

Mutual funds include various equity, fixed-income and blended funds with varying investment strategies. Approximately 64% of mutual fund investments consist of equity investments. The investment objective of equity funds is long-term capital appreciation with current income. The remaining mutual fund investments consist of U.S. fixed-income securities, including investment-grade U.S. Treasury securities, U.S. government agency securities and mortgage-backed securities, corporate bonds and notes and collateralized mortgage obligations. The investment objective of fixed-income funds is to maximize investment return while preserving investment principal. Corporate bonds and notes include investment-grade bonds and notes of U.S. companies from diversified industries. U.S. government agency securities include obligations of Ginnie Mae. States and political subdivisions include fixed income municipal securities. The Corporation’s investment strategies prohibit selling assets short and the use of derivatives. Additionally, the Corporation’s defined benefit plans do not directly invest in real estate, commodities, or private investments.

The asset allocation optimization model is used to estimate the expected long-term rate of return for a given asset allocation strategy. Expectations of returns for each asset class are based on comprehensive reviews of historical data and economic/financial market theory. During periods with volatile interest rates and equity security prices, the model may call for changes in the allocation of plan investments to achieve desired returns. Management assumed a long-term rate of return of 7.75% in the determination of the net periodic benefit cost for 2012. The expected long-term rate of return on assets was selected from within the reasonable range of rates determined by historical real returns, net of inflation, for the asset classes covered by the plan’s investment policy and projections of inflation over the long-term period during which benefits are payable to plan participants.

As of December 31, 2012, expected future benefit payments related to the Corporation’s defined benefit plans were as follows:


2013	$	7,282
2014		7,720
2015		8,263
2016		8,688
2017		9,178
2018 through 2022		52,841

	$	93,972

The Corporation expects to contribute $1.0 million to the defined benefit plans during 2013.

Supplemental Executive Retirement Plan. The Corporation maintains a supplemental executive retirement plan (“SERP”) for one active key executive. The plan provides for target retirement benefits, as a percentage of pay, beginning at age 55. The target percentage is 45 percent of pay at age 55, increasing to 60 percent at age 60 and later. Benefits under the SERP are reduced, dollar-for-dollar, by benefits received under the profit sharing, non-qualified profit sharing, defined benefit retirement and restoration plans, described above, and any social security benefits.

Savings Plans

401(k) Plan and Thrift Incentive Plan. The Corporation maintains a 401(k) stock purchase plan that permits each participant to make before- or after-tax contributions in an amount not less than 2% and not exceeding 50% of eligible compensation and subject to dollar limits from Internal Revenue Service regulations. The Corporation matches 100% of the employee’s contributions to the plan based on the amount of each participant’s contributions up to a maximum of 6% of eligible compensation. Eligible employees must complete 90 days of service in order to enroll and vest in the Corporation’s matching contributions immediately. Expense related to the plan totaled $10.8 million in 2012, $10.2 million in 2011, and $9.8 million in 2010. The Corporation’s matching contribution is initially invested in the Cullen/Frost common stock fund. However, employees may immediately reallocate the Corporation’s matching portion, as well as invest their individual contribution, to any of a variety of investment alternatives offered under the 401(k) Plan.

The Corporation maintains a thrift incentive stock purchase plan to offer certain employees whose participation in the 401(k) plan is limited an alternative means of receiving comparable benefits. Expense related to this plan was not significant during 2012, 2011 and 2010.

Stock Compensation Plans

The Corporation has one active executive stock plan (the 2005 Omnibus Incentive Plan) and one active outside director stock plan (the 2007 Outside Directors Incentive Plan). The executive stock plan was established to help the Corporation retain and motivate key employees, while the outside director stock plans were established as a means to compensate outside directors for their service to the Corporation. All of the plans have been approved by the Corporation’s shareholders. The Compensation and Benefits Committee (“Committee”) of the Corporation’s Board of Directors has sole authority to select the employees, establish the awards to be issued, and approve the terms and conditions of each award contract under the executive stock plans.

During 2005, the 2005 Omnibus Incentive Plan (“2005 Plan”) was established to replace all other previously approved executive stock plans and the remaining shares authorized for grant under the 2001 Stock Plan were cancelled. Under the 2005 Plan, the Corporation may grant, among other things, nonqualified stock options, incentive stock options, stock awards, stock award units, stock appreciation rights, or any combination thereof to certain employees.

During 2007, the 2007 Outside Directors Incentive Plan (the “2007 Directors Plan”) was established to replace the 1997 Directors Plan. The 2007 Directors Plan allows the Corporation to grant nonqualified stock options, stock awards and stock award units to outside directors. Subject to the terms of the plan, stock options, stock awards and/or stock award units may be awarded in such number, and upon such terms, and at any time and from time to time as determined by the Committee.

Options awarded under the 2005 Plan during the periods presented have a ten-year life and generally vest in equal annual installments over a four-year period. Non-vested stock awards/stock units awarded under the 2005 Plan generally have a four-year-cliff vesting period. No options were awarded under the 2007 Directors Plan during the reported periods. Director deferred stock units awarded under the 2007 Directors Plan have immediate vesting. Upon retirement from the Corporation’s board of directors, non-employee directors will receive one share of the Corporation’s common stock for each deferred stock unit held. Outstanding non-vested stock units and director deferred stock units receive equivalent dividend payments as such dividends are declared on the Corporation’s common stock.

Each award from all plans is evidenced by an award agreement that specifies the option price, the duration of the option, the number of shares to which the option pertains, and such other provisions as the Committee determines. The option price for each grant is at least equal to the fair market value of a share of Cullen/Frost’s common stock on the date of grant. Options granted expire at such time as the Committee determines at the date of grant and in no event does the exercise period exceed a maximum of ten years. Upon a change-in-control of Cullen/Frost, as defined in the plans, all outstanding options and non-vested stock awards/units immediately vest.

A combined summary of activity in the Corporation’s active stock plans is presented in the following table.


							Non-Vested Stock Awards/Stock Units Outstanding					Stock Options Outstanding

	Shares Available for Grant			Director Deferred Stock Units Outstanding			Number of Shares			Weighted- Average Grant-Date Fair Value		Number of Shares			Weighted- Average Exercise Price

Balance, January 1, 2010		3,445,507			12,688			233,200		$	52.27		4,600,455		$	51.18
Granted		(814,910	)		5,030			56,300			52.46		753,580			52.51
Stock options exercised		-			-			-			-		(819,650	)		47.34
Stock awards vested		-			-			(61,950	)		56.73		-			-
Deferred stock unit conversions		-			(1,203	)		-			-		-			-
Forfeited		150,500			-			-			-		(150,500	)		52.49
Cancelled/expired		(21,750	)		-			-			-		-			-

Balance, December 31, 2010		2,759,347			16,515			227,550			51.10		4,383,885			52.08
Granted		(868,267	)		5,577			56,300			48.00		806,390			48.02
Stock options exercised		-			-			-			-		(148,203	)		50.18
Stock awards vested		-			-			(114,320	)		50.19		-			-
Forfeited		73,250			-			-			-		(73,250	)		51.43
Cancelled/expired		(875	)		-			-			-		-			-

Balance, December 31, 2011		1,963,455			22,092			169,530			50.33		4,968,822			51.49
Granted		(825,542	)		5,632			49,130			54.56		770,780			54.56
Stock options exercised		-			-			-					(206,336	)		50.96
Stock awards vested		-			-			(30,100	)		52.44		-			-
Forfeited		19,750			-			-					(19,750	)		50.49
Cancelled/expired		(250	)		-			-					-

Balance, December 31, 2012		1,157,413			27,724			188,560		$	51.67		5,513,516		$	51.94

Of the shares available for grant included in the above table as of December 31, 2012, a total of 63,043 shares may be granted as full value awards, meaning awards other than in the form of stock options or stock appreciation rights, and which are settled by the issuance of shares.

Other information regarding options outstanding and exercisable as of December 31, 2012 is as follows:


			Options Outstanding						Options Exercisable
Range of Exercise Prices			Number of Shares		Weighted- Average Exercise Price		Weighted- Average Remaining Contractual Life in Years		Number of Shares		Weighted- Average Exercise Price

$ 45.01	-	$ 50.00		1,401,394	$	48.37		7.07		807,474	$	49.27
50.01	-	55.00		3,420,072		52.23		6.89		2,110,954		51.48
55.01	-	60.00		692,050		57.73		3.85		689,550		57.73

		Total		5,513,516		51.94		6.55		3,607,978		52.18

The total intrinsic value of outstanding in-the-money stock options and outstanding in-the-money exercisable stock options was $15.5 million and $10.4 million at December 31, 2012.

Shares issued in connection with stock compensation awards are issued from available treasury shares. If no treasury shares are available, new shares are issued from available authorized shares. Shares issued in connection with stock compensation awards along with other related information were as follows:


	2012		2011		2010

New shares issued from available authorized shares		207,586		140,739		666,222
Issued from available treasury stock		15,600		29,824		176,991

Total		223,186		170,563		843,213

Proceeds from stock option exercises	$	10,516	$	7,438	$	38,807
Intrinsic value of stock options exercised		1,538		1,475		6,639
Fair value of stock awards/units vested		1,649		6,161		3,322

Stock-based Compensation Expense Stock-based compensation expense is recognized ratably over the requisite service period for all awards. Stock-based compensation expense and the related income tax benefit was as follows:


	2012		2011		2010

Stock options	$	9,663	$	10,834	$	9,839
Non-vested stock awards/stock units		2,843		4,799		4,786
Deferred stock-units		330		330		300

Total	$	12,836	$	15,963	$	14,925

Income tax benefit	$	4,493	$	5,587	$	5,224

Unrecognized stock-based compensation expense at December 31, 2012 was as follows:


Stock options	$	17,675
Non-vested stock awards/stock units		2,933

Total	$	20,608

The weighted-average period over which this unrecognized expense related to stock options was expected to be recognized was 2.8 years. The weighted-average period over which this unrecognized expense related to non-vested stock awards/stock units was expected to be recognized was 2.6 years.

Valuation of Stock-Based Compensation. The fair value of the Corporation’s employee stock options granted is estimated on the measurement date, which, for the Corporation, is the date of grant. The fair value of stock options is estimated using a binomial lattice-based valuation model that takes into account employee exercise patterns based on changes in the Corporation’s stock price and other variables, and allows for the use of dynamic assumptions about interest rates and expected volatility. The fair value of stock options granted prior to the fourth quarter of 2006 was estimated using the Black-Scholes option-pricing model.

The weighted-average fair value of stock options granted during 2012, 2011 and 2010 estimated using a binomial lattice-based valuation model, was $11.07, $9.78, and $12.94. The assumptions used to determine the fair value of options granted are detailed in the table below.

2012

2011

2010

Risk-free interest rate

0.10% to 3.58%

0.01% to 3.91%

0.14% to 4.98%

Weighted-average risk-free interest rate

1.85%

2.23%

2.79%

Dividend yield

3.28%

2.84%

2.79%

Expected market price volatility

24.97% to 31.15%

24.87% to 31.32%

31.11% to 41.40%

Weighted-average expected market price volatility

28.06%

29.43%

34.65%

Expected term

6.0 to 6.9 Years

6.0 to 7.0 Years

5.6 to 6.9 Years

Weighted-average expected term

6.5 Years

6.3 Years

6.0 Years

Expected volatility is based on the short-term historical volatility (estimated over the most recent two years) and the long-term historical volatility (estimated over a period at least equal to the contractual term of the options) of the Corporation’s stock, and other factors. A variance targeting methodology is utilized to estimate the convergence, or mean reversion, from short-term to long-term volatility within the model. In estimating the fair value of stock options under the binomial lattice-based valuation model, separate groups of employees that have similar historical exercise behavior are considered separately. The expected term of options granted is derived using a regression model and represents the period of time that options granted are expected to be outstanding. The range of expected term results from certain groups of employees exhibiting different behavior.

The fair value of non-vested stock awards/stock units and deferred stock units for the purposes of recognizing stock-based compensation expense is the market price of the stock on the measurement date, which, for the Corporation, is the date of the award.