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40
Our key economic assumptions and the sensitivity of the
current fair value of MSRs to an immediate adverse change
in those assumptions are shown in Note 20 (Securitizations
and Variable Interest Entities) to Financial Statements.
In recent years, there have been significant market-driven
fluctuations in loan prepayment speeds and the discount
rate. These fluctuations can be rapid and may be significant
in the future. Therefore, estimating prepayment speeds within
a range that market participants would use in determining the
fair value of MSRs requires significant management judgment.
Pension Accounting
We use four key variables to calculate our annual pension
cost; size and characteristics of the employee population,
actuarial assumptions, expected long-term rate of return on
plan assets, and discount rate. We describe below the effect
of each of these variables on our pension expense.
SIZE AND CHARACTERISTICS OF THE EMPLOYEE POPULATION
Pension expense is directly related to the number of employ-
ees covered by the plans, and other factors including salary,
age and years of employment.
ACTUARIAL ASSUMPTIONS
To estimate the projected benefit obligation, actuarial
assumptions are required about factors such as the rates of
mortality, turnover, retirement, disability and compensation
increases for our participant population. These demographic
assumptions are reviewed periodically. In general, the range
of assumptions is narrow.
EXPECTED LONG-TERM RATE OF RETURN ON PLAN ASSETS
We determine the expected return on plan assets each year
based on the composition of assets and the expected long-
term rate of return on that portfolio. The expected long-term
rate of return assumption is a long-term assumption and is
not anticipated to change significantly from year to year.
To determine if the expected rate of return is reasonable,
we consider such factors as (1) the actual return earned on
plan assets, (2) historical rates of return on the various asset
classes in the plan portfolio, (3) projections of returns on
various asset classes, and (4) current/prospective capital mar-
ket conditions and economic forecasts. Including 2005, we
have used an expected rate of return of 9% on plan assets
for the past nine years. In light of the market conditions in
recent years, including a marked increase in volatility, we
reduced the expected long-term rate of return on plan assets
to 8.75% for 2006. Differences in each year, if any, between
expected and actual returns are included in our unrecognized
net actuarial gain or loss amount. We generally amortize any
unrecognized net actuarial gain or loss in excess of a 5%
corridor (as defined in FAS 87, Employers’ Accounting for
Pensions) in net periodic pension expense calculations over
the next five years. Our average remaining service period is
approximately 11 years. See Note 15 (Employee Benefits and
Other Expenses) to Financial Statements for information on
funding, changes in the pension benefit obligation, and plan
assets (including the investment categories, asset allocation
and the fair value).
We use November 30 as the measurement date for our
pension assets and projected benefit obligations. If we were
to assume a 1% increase/decrease in the expected long-term
rate of return, holding the discount rate and other actuarial
assumptions constant, pension expense would decrease/increase
by approximately $50 million.
DISCOUNT RATE
We use the discount rate to determine the present value of
our future benefit obligations. It reflects the rates available
on long-term high-quality fixed-income debt instruments,
and is reset annually on the measurement date. As the basis
for determining our discount rate, we review the Moody’s
Aa Corporate Bond Index, on an annualized basis, and the
rate of a hypothetical portfolio using the Hewitt Yield Curve
(HYC) methodology, which was developed by our indepen-
dent actuary. The instruments used in both the Moody’s Aa
Corporate Bond Index and the HYC consist of high quality
bonds for which the timing and amount of cash outflows
approximates the estimated payouts of our Cash Balance
Plan. We lowered our discount rate to 5.75% in 2005 from
6% in 2004 and 6.5% in 2003, reflecting the decline in
market interest rates during these periods.
If we were to assume a 1% increase in the discount rate,
and keep the expected long-term rate of return and other
actuarial assumptions constant, pension expense would
decrease by approximately $59 million. If we were to
assume a 1% decrease in the discount rate, and keep other
assumptions constant, pension expense would increase
by approximately $104 million. The decrease in pension
expense due to a 1% increase in discount rate differs from the
increase in pension expense due to a 1% decrease in discount
rate due to the impact of the 5% gain/loss corridor.