3. Employee Benefit Plans

Stock-Based Compensation Plans

The Company maintains stock-based compensation plans primarily for its key employees and directors, although the plans permit awards to others expected to make significant contributions to the future of the Company. The plans authorize the compensation committee of the Company's board of directors (the board committee) to award a variety of stock and stock-based incentives, such as restricted stock, restricted stock units, nonqualified and incentive stock options, stock bonus shares, or performance-based shares. The award recipients and the terms of awards, including price, granted under these plans are determined by the board committee. Upon a change of control, as defined in the plans, all options or other awards become fully vested and all restrictions lapse. The Company had 473,918 shares available for grant under stock-based compensation plans at year-end 2012. The Company generally issues its common stock out of treasury stock, to the extent available, for share issuances related to its stock-based compensation plans.

The Company recognizes compensation cost for all stock-based payments to employees based on the grant date estimate of fair value for those awards. Total stock-based compensation expense was $4,766,000, $3,934,000, and $2,754,000 in 2012, 2011, and 2010, respectively, and is included in selling, general, and administrative expenses in the accompanying consolidated statement of income.

The components of pre-tax stock-based compensation expense are as follows:

(In thousands)	2012		2011		2010
Restricted Stock Unit Awards	$	3,731	$	3,212	$	2,381
Stock Option Awards		954		628		287
Employee Stock Purchase Plan Awards		81		94		86
Total	$	4,766	$	3,934	$	2,754

The Company has elected to recognize excess income tax benefits from stock option exercises and the vesting of restricted stock units in capital in excess of par value using the tax return ordering approach. The Company measures the tax benefit associated with excess tax deductions related to stock-based compensation expense by multiplying the excess tax deductions by the statutory tax rates. The Company recognized income tax benefits in capital in excess of par value of $132,000, $371,000, and $26,000 in 2012, 2011, and 2010, respectively, associated with stock-based compensation.

Non-Employee Director Restricted Stock Units

In general, the Company grants 5,000 restricted stock units (RSUs) to each of its non-employee directors in the first quarter of each fiscal year. The shares vest ratably on the last day of each fiscal quarter within the year. In addition, the Company has granted 10,000 RSUs to each of its non-employee directors, which will only vest and compensation expense will only be recognized upon a change in control as defined in the Company's 2006 equity incentive plan. These RSUs, which total 50,000 outstanding in the aggregate and have a grant date fair value of $891,000, will be forfeited if a change in control does not occur before the last day of the first quarter of 2015.

Performance-Based Restricted Stock Units

The Company grants performance-based RSUs to executive officers of the Company. Each performance-based RSU represents the right to receive one share of the Company's common stock upon vesting. The RSUs are subject to adjustment based on the achievement of a performance measure selected for the fiscal year, which is a specified target for adjusted earnings before interest, taxes, depreciation, and amortization (adjusted EBITDA) generated from continuing operations. Following adjustment, the RSUs are subject to additional time-based vesting, and vest in three equal annual installments, provided that the executive officer is employed by the Company on the applicable vesting dates.

The Company recognizes compensation expense associated with performance-based RSUs ratably over the requisite service period for each separately-vesting portion of the award based on the grant date fair value. Compensation expense recognized is net of forfeitures and remeasured each reporting period until the total number of RSUs to be issued is known. Unrecognized compensation expense related to the unvested performance-based RSUs totaled approximately $1,325,000 at December 29, 2012, and will be recognized over a weighted average period of 1.4 years.

The performance-based RSU agreements provide for forfeiture in certain events, such as voluntary or involuntary termination of employment, and for acceleration of vesting in certain events, such as death, disability or a change in control of the Company. If the officer dies or is disabled prior to the vesting date, then a ratable portion of the RSUs will vest. If a change in control occurs prior to the end of the performance period, the officer will receive the target RSU amount; otherwise, the officer will receive the number of deliverable RSUs based on the achievement of the performance goal, as stated in the RSU agreements.

Time-Based Restricted Stock Units

The Company grants time-based RSUs to certain employees of the Company. Each time-based RSU represents the right to receive one share of the Company's common stock upon vesting. The Company is recognizing compensation expense associated with these time-based RSUs ratably over the requisite service period for the entire award based on the grant date fair value and net of forfeitures. The time-based RSU agreement provides for forfeiture in certain events, such as voluntary or involuntary termination of employment, and for acceleration of vesting in certain events, such as death, disability, or a change in control of the Company. Unrecognized compensation expense related to the time-based RSUs totaled approximately $1,806,000 at December 29, 2012, and will be recognized over a weighted average period of 1.7 years.

A summary of the activity of the Company's unvested restricted stock units for 2010, 2011, and 2012 is as follows:

Unvested Restricted Stock Units	Units (In thousands)			Weighted Average Grant- Date Fair Value
Unvested RSUs at January 2, 2010		212		$	17.89
Granted		245		$	14.53
Vested		(86	)	$	20.43
Forfeited / Expired		(59	)	$	9.56
Unvested RSUs at January 1, 2011		312		$	16.77
Granted		184		$	24.91
Vested		(159	)	$	19.90
Forfeited / Expired		(8	)	$	8.81
Unvested RSUs at December 31, 2011		329		$	20.02
Granted		179		$	21.95
Vested		(144	)	$	19.97
Forfeited / Expired		(1	)	$	27.74
Unvested RSUs at December 29, 2012		363		$	20.98

The total fair value of shares vested was $3,321,000, $4,071,000, and $1,856,000 in 2012, 2011, and 2010, respectively.

Stock Options

Options granted from 2010 through 2012 have been nonqualified options that vest over three years and are not exercisable until vested. To date, all options have been granted at an exercise price equal to the fair market value of the Company's common stock on the date of grant. The stock options vest in three equal annual installments beginning on the first anniversary of the grant date, provided that the recipient remains employed by the Company on the applicable vesting dates. The Company is recognizing compensation expense associated with these stock options ratably over the requisite service period for the entire award based on the grant date fair value and net of forfeitures. Unrecognized compensation expense related to these stock options totaled approximately $1,181,000 at December 29, 2012, and will be recognized over a weighted average period of 1.5 years.

The fair value of each option grant was estimated on the grant date using the Black-Scholes option-pricing model, assuming no expected dividends, with the following assumptions:

	2012			2011			2010
Weighted-average Exercise Price	$	21.91		$	24.90		$	14.17
Weighted-average Grant Date Fair Value	$	11.69		$	12.85		$	7.39
Volatility		50	%		45	%		45	%
Risk-Free Interest Rate		1.38	%		2.86	%		3.04	%
Expected Life of Options	7.6 years			7.4 years			7.5 years

The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. In addition, option-pricing models require the input of highly subjective assumptions, including expected stock price volatility. Expected stock price volatility was calculated based on a review of the Company's actual historic stock prices commensurate with the expected life of the award. The expected option life was derived based on a review of the Company's historic option holding periods, including consideration of the holding period inherent in currently vested but unexercised options. The risk-free interest rate is based on the yield on zero-coupon U.S. Treasury securities for a period that is commensurate with the expected term of the option. The compensation expense recognized for all equity-based awards is net of estimated forfeitures. Forfeitures are estimated based on an analysis of actual option forfeitures.

A summary of the Company's stock option activity for 2010, 2011, and 2012 is as follows:

(in thousands, except per share amounts)	Number of Shares			Weighted Average Exercise Price		Weighted Average Remaining Contractual Life	Aggregate Intrinsic Value (a)
Options Outstanding at January 2, 2010		21		$	19.13
Granted		140		$	14.17
Options Outstanding at January 1, 2011		161		$	14.82
Granted		82		$	24.90
Exercised		(8	)	$	20.01
Options Outstanding at December 31, 2011		235		$	18.15
Granted		83		$	21.91
Exercised		(18	)	$	17.54
Options Outstanding at December 29, 2012		300		$	19.23	8.0 years	$	2,109
Vested and Unvested Expected to Vest, End of Year		300		$	19.23	8.0 years	$	2,109
Options Exercisable, End of Year		116		$	16.69	7.4 years	$	1,111

(a)	The closing price per share on the last trading day prior to December 29, 2012 was $26.26.

A summary of the Company's stock option exercises in 2012 and 2011 is as follows. There were no stock option exercises in 2010.

(In thousands)	2012		2011
Total intrinsic value of options exercised	$	119	$	39
Cash received from options exercised	$	319	$	150

Employee Stock Purchase Plan

Substantially all of the Company's full-time U.S. employees are eligible to participate in its employee stock purchase plan. Under the plan, shares of the Company's common stock may be purchased at a 15% discount from the fair market value at the beginning or end of the purchase period, whichever is lower. Shares purchased under the plan are subject to a one-year resale restriction and are purchased through payroll deductions of up to 10% of each participating employee's gross wages. For the 2012, 2011, and 2010 plan years, the Company issued 17,490, 12,509, and 25,466 shares, respectively, of its common stock under this plan.

401(k) Savings and Other Defined Contribution Plans

The Company's U.S. subsidiaries participate in the Kadant Inc. 401(k) Retirement Savings Plan sponsored by the Company. Contributions to the plan are made by both the employee and the Company and are immediately vested. Company contributions are based upon the level of employee contributions.

Certain of the Company's subsidiaries offer other retirement plans, the majority of which are defined contribution plans. Company contributions to these plans are based on formulas determined by the Company.

For these plans, the Company contributed and charged to expense approximately $2,517,000, $2,294,000, and $2,174,000 in 2012, 2011, and 2010, respectively.

Defined Benefit Pension Plan and Post-Retirement Welfare Benefits Plans

The Company sponsors a noncontributory defined benefit retirement plan for the benefit of eligible employees at its Kadant Solutions division and the corporate office. Benefits under the plan are based on years of service and employee compensation. Funds are contributed to a trustee as necessary to provide for current service and for any unfunded projected benefit obligation over a reasonable period. Effective December 31, 2005, this plan was closed to new participants. The Company also has a post-retirement welfare benefits plan for the benefit of eligible employees at its Kadant Solutions division (included in the table below in "Other Benefits"). No future retirees are eligible for this post-retirement welfare benefits plan, and the plans include limits on the employer's contributions.

In March 2011, the Company approved a Restoration Plan (included in the table below in "Other Benefits") for the benefit of certain executive officers who are also participants of the noncontributory defined benefit retirement plan. This plan provides a benefit equal to the benefits lost under the noncontributory defined benefit retirement plan as a consequence of applicable Internal Revenue Service limits on the levels of contributions and benefits.

The Company's Kadant Lamort subsidiary sponsors a defined benefit pension plan (included in the table below in "Other Benefits"). Benefits under this plan are based on years of service and projected employee compensation

The Company's Kadant Johnson subsidiary also offers a post-retirement welfare benefits plan (included in the table below in "Other Benefits") to its U.S. employees upon attainment of eligible retirement age. This plan was closed to employees who did not meet its retirement eligibility requirements on January 1, 2012.

In accordance with ASC 715, "Compensation–Retirement Benefits," (ASC 715), an employer is required to recognize the overfunded or underfunded status of a defined benefit post-retirement plan as an asset or liability in its balance sheet and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. These amounts will be subsequently recognized as net periodic pension cost pursuant to the Company's historical accounting policy for amortizing such amounts. Further, actuarial gains and losses that arise in subsequent periods and are not recognized as net periodic pension cost in the same periods will be recognized as a component of accumulated other comprehensive items. The actuarial loss and prior service loss included in accumulated other comprehensive items and expected to be recognized in net periodic pension cost in 2013 are $662,000 and $140,000, respectively.

The following table summarizes the change in benefit obligation; the change in plan assets; the unfunded status; and the amounts recognized in the balance sheet for the Company's pension benefits and other benefits plans. The measurement date for all items set forth below is the last day of the fiscal year presented.

	Pension Benefits						Other Benefits
(In thousands)	2012			2011			2012			2011
Change in Benefit Obligation:
Benefit obligation at beginning of year	$	31,594		$	26,734		$	5,402		$	3,975
Service cost		991			855			143			187
Interest cost		1,313			1,298			225			237
Actuarial loss		1,046			4,451			425			527
Prior service cost		–			–			–			960
Benefits paid		(3,201	)		(1,744	)		(275	)		(437	)
Effect of currency translation		–			–			48			(47	)
Benefit obligation at end of year	$	31,743		$	31,594		$	5,968		$	5,402
Change in Plan Assets:
Fair value of plan assets at beginning of year	$	26,393		$	23,965		$	–		$	–
Actual return on plan assets		2,576			3,272			–			–
Employer contribution		960			900			275			437
Benefits paid		(3,201	)		(1,744	)		(275	)		(437	)
Fair value of plan assets at end of year	$	26,728		$	26,393		$	–		$	–
Unfunded status	$	(5,015	)	$	(5,201	)	$	(5,968	)	$	(5,402	)
Accumulated benefit obligation as of year-end	$	26,270		$	25,928		$	1,777		$	1,345
Amounts Recognized in the Balance Sheet Consist of:
Current liability	$	–		$	–		$	(251	)	$	(444	)
Non-current liability	$	(5,015	)	$	(5,201	)	$	(5,717	)	$	(4,958	)
Amounts Recognized in Accumulated Other Comprehensive Items Before Tax Consist of:
Unrecognized net actuarial loss	$	(9,656	)	$	(10,205	)	$	(1,251	)	$	(857	)
Unrecognized prior service cost		(273	)		(329	)		(882	)		(908	)
Total	$	(9,929	)	$	(10,534	)	$	(2,133	)	$	(1,765	)
Changes in Amounts Recognized in Accumulated Other Comprehensive Items Before Tax:
Current year unrecognized net actuarial loss	$	(85	)	$	(2,608	)	$	(425	)	$	(527	)
Current year prior service cost		–			–			–			(960	)
Amortization of unrecognized prior service cost		56			55			28			15
Amortization of unrecognized net actuarial loss		634			433			36			28
Effect of currency translation		–			–			(7	)		4
Total	$	605		$	(2,120	)	$	(368	)	$	(1,440	)

The weighted-average assumptions used to determine the benefit obligation as of year-end were as follows:

	Pension Benefits						Other Benefits
	2012			2011			2012			2011
Discount rate		3.89	%		4.28	%		3.52	%		4.44	%
Rate of compensation increase		3.50	%		4.00	%		3.15	%		3.28	%

The projected benefit obligations and fair value of plan assets for the Company's pension plans with projected benefit obligations in excess of plan assets were as follows:

	Pension Benefits				Other Benefits
(In thousands)	2012		2011		2012		2011
Pension Plans with Projected Benefit Obligations in Excess of Plan Assets:
Projected benefit obligation	$	31,743	$	31,594	$	2,456	$	1,790
Fair value of plan assets	$	26,728	$	26,393	$	–	$	–

The accumulated benefit obligations and fair value of plan assets for the Company's pension plans with accumulated benefit obligations in excess of plan assets were as follows:

	Pension Benefits				Other Benefits
(In thousands)	2012		2011		2012		2011
Pension Plans with Accumulated Benefit Obligations in Excess of Plan Assets:
Accumulated benefit obligation	$	–	$	–	$	1,777	$	1,345
Fair value of plan assets	$	–	$	–	$	–	$	–

The components of net periodic benefit cost were as follows:

	Pension Benefits									Other Benefits
(In thousands)	2012			2011			2010			2012		2011		2010
Components of Net Periodic Benefit Cost:
Service cost	$	991		$	855		$	820		$	143	$	187	$	100
Interest cost		1,313			1,298			1,294			225		237		218
Expected return on plan assets		(1,616	)		(1,429	)		(1,412	)		–		–		–
Recognized net actuarial loss		634			433			439			36		28		13
Amortization of prior service cost (income)		56			55			55			28		15		(58	)
Net periodic benefit cost		1,378			1,212			1,196			432		467		273
Curtailment gain		–			–			–			–		–		(219	)
Net periodic benefit cost	$	1,378		$	1,212		$	1,196		$	432	$	467	$	54

The weighted-average assumptions used to determine net periodic benefit cost were as follows:

	Pension Benefits									Other Benefits
	2012			2011			2010			2012			2011			2010
Discount rate		4.28	%		5.25	%		5.75	%		4.44	%		5.04	%		5.52	%
Expected long-term return on plan assets		6.25	%		6.25	%		7.00	%		–			–			–
Rate of compensation increase		4.00	%		4.00	%		4.00	%		3.57	%		3.28	%		2.00	%

In developing the overall expected long-term return on plan assets assumption, a building block approach was used in which rates of return in excess of inflation were considered separately for equity securities, debt securities, and other assets. The excess returns were weighted by the representative target allocation and added along with an appropriate rate of inflation to develop the overall expected long-term return on plan assets assumption. The Company believes this determination is consistent with ASC 715.

Assumed weighted-average healthcare cost trend rates as of year-end were as follows:

	2012			2011
Healthcare cost trend rate assumed for next year		8.00	%		8.00	%
Ultimate healthcare cost trend rate		0.00	%		0.00	%
Year assumed rate reaches ultimate rate		2018			2018

Assumed healthcare cost trend rates can have a significant effect on the amounts reported for healthcare benefits. A one-percentage point change in assumed healthcare cost trend rates would have the following effects:

(In thousands)	1 Percentage Point Increase			1 Percentage Point Decrease
Effect on total of service and interest cost components—(expense) income	$	–		$	–
Effect on post-retirement benefit obligation—(increase) decrease	$	(1	)	$	1

Plan Assets

The fair values of the Company's noncontributory defined benefit retirement plan assets at year-end 2012 and 2011 by asset category are as follows:

	2012 Fair Value Measurement
(In thousands)	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
Asset Category:
Mutual Funds:
U.S. Equity (a)	$	3,331	$	–	$	–	$	3,331
International Equity (a)		848		–		–		848
Fixed Income (b)		14,641		7,908		–		22,549
Total Assets	$	18,820	$	7,908	$	–	$	26,728

	2011 Fair Value Measurement
(In thousands)	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
Asset Category:
Mutual Funds:
U.S. Equity (a)	$	3,040	$	–	$	–	$	3,040
International Equity (a)		697		–		–		697
Fixed Income (b)		14,186		8,470		–		22,656
Total Assets	$	17,923	$	8,470	$	–	$	26,393

(a)	Common stock index funds.

(b)	Investments in commingled funds that invest in a diversified blend of investment and non-investment grade fixed income securities.

Description of Fair Value Measurements

Level 1 – Quoted, active market prices for identical assets. Share prices of the funds, referred to as a fund's Net Asset Value (NAV), are calculated daily based on the closing market prices and accruals of securities in the fund's total portfolio (total value of the fund) divided by the number of fund shares currently issued and outstanding. Redemptions of the mutual funds occur by contract at the respective fund's redemption date NAV.

Level 2 – Observable inputs other than Level 1 prices, based on model-derived valuations in which all significant inputs are observable in active markets. The NAVs of the funds are calculated monthly based on the closing market prices and accruals of securities in the fund's total portfolio (total value of the fund) divided by the number of fund shares currently issued and outstanding. Redemptions of the mutual funds occur by contract at the respective fund's redemption date NAV.

Level 3 – Unobservable inputs based on the Company's own assumptions.

The Company has developed an investment policy for its noncontributory defined benefit retirement plan. The investment strategy is to emphasize total return, that is, the aggregate return from capital appreciation and dividend and interest income. The primary objective of the investment management for the plan's assets is the emphasis on consistent growth, specifically, growth in a manner that protects the plan's assets from excessive volatility in market value from year to year. The investment policy takes into consideration the benefit obligations, including timing of distributions.

The primary objective for the noncontributory defined benefit retirement plan is to provide long-term capital appreciation through investment in equity and debt securities. The following target asset allocation has been established for the plan:

Asset Category	Minimum			Neutral			Maximum
Equity securities		10	%		15	%		20	%
Debt securities		80	%		85	%		90	%
Total					100	%

All equity securities must be drawn from recognized securities exchanges. Debt securities must be weighted to reflect a portfolio average maturity of not more than ten years, with average benchmark duration of five years. The credit quality must equal or exceed high investment grade quality ("Baa" or better).

Cash Flows

Contributions

The Company expects to make cash contributions of $1,080,000 to its noncontributory defined benefit retirement plan in 2013. For the remaining pension and post-retirement welfare benefits plans, no cash contributions other than to fund current benefit payments are expected in 2013.

Estimated Future Benefit Payments

The following benefit payments, which reflect future service as appropriate, are expected to be paid. The benefit payments are based on the same assumptions used to measure the Company's benefit obligation at year-end 2012.

(In thousands)	Pension Benefits		Other Benefits
2013	$	1,614	$	252
2014		1,318		440
2015		2,115		259
2016		1,474		327
2017		3,039		894
2018-2022		12,718		2,037

Information and Assumptions for the Post-Retirement Welfare Benefits Plan

All eligible retirees of the Company's Kadant Solutions division are currently participating in a post-retirement welfare benefits plan, with no future retirees eligible to participate. Effective September 1, 2003, the monthly contribution to the plan was capped at $358 per participant. For the majority of the retirees in the plan, no healthcare cost trend rate is assumed, as the Company cap applies. For the remainder, the healthcare cost trend rate is assumed to be 8% in 2012, decreasing to an ultimate rate of 0% in 2018, at which time the plan caps on benefits are expected to apply to all benefits.

All eligible retirees of the Company's Kadant Johnson Inc. subsidiary are currently participating in a post-retirement welfare benefits plan. Kadant Johnson pays 75% of all plan costs for retirees with a retirement date prior to January 1, 2005, and 50% of all plan costs for retirees with a retirement date after January 1, 2005, with no limits on its contributions up to annual employee and plan stop loss limitations. This plan was closed to employees who did not meet its retirement eligibility requirements on January 1, 2012. The medical healthcare cost trend rate no longer affects the amounts reported for the health care benefits in this plan.