Dominion Power 2005 Annual Report Download - page 32

Management’s Discussion and Analysis of Financial Condition and Results of Operations, Continued
30 Dominion 2005
activities, credit-adjusted risk free rates and cost escalation rates.
AROs currently reported on our Consolidated Balance Sheets were
measured during a period of historically low interest rates. The
impact on measurements of new AROs, using different rates in the
future, may be significant. In the future, if we revise any assump-
tions used to calculate the fair value of existing AROs, we will adjust
the carrying amount of both the ARO liability and related long-lived
asset. We record accretion expense, increasing the ARO liability,
with the passage of time. In 2005, 2004 and 2003, we recognized
$102 million, $91 million and $86 million, respectively, of accre-
tion expense, and expect to incur $124 million in 2006.
A significant portion of our AROs relate to the future decommis-
sioning of our nuclear facilities. At December 31, 2005, nuclear
decommissioning AROs, which are reported in the Dominion Gener-
ation segment, totaled $1.7 billion, representing approximately
77% of our total AROs. Based on their significance, the following
discussion of critical assumptions inherent in determining the fair
value of AROs relates to those associated with our nuclear decom-
missioning obligations.
We obtain from third-party experts periodic site-specific “base
year” cost studies in order to estimate the nature, cost and timing
of planned decommissioning activities for our utility nuclear plants.
We use internal and external cost studies for our merchant nuclear
facilities based on similar methods. These cost studies are based
on relevant information available at the time they are performed;
however, estimates of future cash flows for extended periods are by
nature highly uncertain and may vary significantly from actual
results. In addition, these cost estimates are dependent on subjec-
tive factors, including the selection of cost escalation rates, which
we consider to be a critical assumption.
We determine cost escalation rates, which represent projected
cost increases over time, due to both general inflation and
increases in the cost of specific decommissioning activities, for
each of our nuclear facilities. The use of alternative rates would
have been material to the liabilities recognized. For example, had
we increased the cost escalation rate by 0.5%, the amount recog-
nized as of December 31, 2005 for our AROs related to nuclear
decommissioning would have been $343 million higher.
Employee benefit plans
We sponsor noncontributory defined benefit pension plans and
other postretirement benefit plans for eligible active employees,
retirees and qualifying dependents. The costs of providing benefits
under these plans are dependent, in part, on historical information
such as employee demographics, the level of contributions made to
the plans and earnings on plan assets. Assumptions about the
future, including the expected rate of return on plan assets, dis-
count rates applied to benefit obligations and the anticipated rate
of increase in health care costs and participant compensation, also
have a significant impact on employee benefit costs. The impact on
pension and other postretirement benefit plan obligations associ-
ated with changes in these factors is generally recognized in our
Consolidated Statements of Income over the remaining average
service period of plan participants rather than immediately.
The selection of expected long-term rates of return on plan
assets, discount rates and medical cost trend rates are critical
assumptions. We determine the expected long-term rates of return
on plan assets for pension plans and other postretirement benefit
plans by using a combination of:
•Historical return analysis to determine expected future
risk premiums;
•Forward-looking return expectations derived from the yield on
long-term bonds and the price earnings ratios of major stock
market indices;
•Expected inflation and risk-free interest rate assumptions; and
•Investment allocation of plan assets. The strategic target asset
allocation for our pension fund is 45% U.S. equity securities, 8%
non-U.S. equity securities, 22% debt securities and 25% other,
such as real estate and private equity investments.
Assisted by an independent actuary, we develop assumptions,
which are then compared to the forecasts of other independent
investment advisors to ensure reasonableness. An internal commit-
tee selects the final assumptions. We calculated our pension cost
using an expected return on plan assets assumption of 8.75% for
2005, 2004 and 2003. We calculated our 2005 other postretire-
ment benefit cost using an expected return on plan assets assump-
tion of 8.00% compared to 7.79% and 7.78% for 2004 and 2003,
respectively. The rate used in calculating other postretirement ben-
efit cost is lower than the rate used in calculating pension cost
because of differences in the relative amounts of various types of
investments held as plan assets and because other postretirement
benefit activity, unlike the pension activity, was partially taxable in
2004 and 2003.
Discount rates are determined from analyses performed by a
third-party actuarial firm of AA/Aa rated bonds with cash flows
matching the expected payments to be made under our plans. The
discount rate used to calculate 2005 pension and other postretire-
ment benefit costs was 6.00% compared to the 6.25% and 6.75%
discount rates used to calculate 2004 and 2003 pension and other
postretirement benefit costs, respectively. Lower long-term bond
yields were the primary reason for the decline in the discount rate
from 2004 to 2005.
The medical cost trend rate assumption is established based on
analyses performed by a third-party actuarial firm of various factors
including the specific provisions of our medical plans, actual cost
trends experienced and projected, and demographics of plan par-
ticipants. Our medical cost trend rate assumption as of December
31, 2005 is 9.00% and is expected to gradually decrease to 5.00%
in later years.
The following table illustrates the effect on cost of changing the
critical actuarial assumptions previously discussed, while holding all
other assumptions constant:
Increase in
Net Periodic Cost
Other
Actuarial Change in Pension Postretirement
Assumption Assumption Benefits Benefits
(millions)
Discount rate (0.25%) $14 $ 7
Rate of return on plan assets (0.25%) 10 2
Healthcare cost trend rate 1% N/A 26
In addition to the effects on cost, a 0.25% decrease in the dis-
count rate would increase our projected pension benefit obligation
by $138 million and would increase our accumulated postretire-
ment benefit obligation by $53 million.
Accounting for regulated operations
The accounting for our regulated electric and gas operations differs
from the accounting for nonregulated operations in that we are
required to reflect the effect of rate regulation in our Consolidated
Financial Statements. Specifically, our regulated businesses record