PENSION AND OTHER POSTRETIREMENT BENEFIT PLANS

We have noncontributory union and non-union defined benefit pension plans covering eligible employees. The plans provide defined benefits based on years of service and final average pay. In 2012, we made total contributions of $7.3 million ($33.8 million in 2011, of which $20.0 million was contributed in shares of ALLETE common stock). We also have a defined contribution pension plan covering substantially all employees. The 2012 plan year employer contributions, which are made through the employee stock ownership plan portion of the RSOP, totaled $7.7 million ($7.3 million for the 2011 plan year.) (See Note 12. Common Stock and Earnings Per Share and Note 16. Employee Stock and Incentive Plans).

In 2006, the non-union defined benefit pension plan was amended to suspend further crediting of service to the plan and to close the plan to new participants. In conjunction with those amendments, contributions were increased to the RSOP. In 2010, the Minnesota Power union defined benefit pension plan was amended to close the plan to new participants beginning February 1, 2011.

We have postretirement health care and life insurance plans covering eligible employees. In 2010, our postretirement health plan was amended to close the plan to employees hired after January 31, 2011. The full eligibility requirement was also amended in 2010, to age 55 with 10 years of participation in the plan. The postretirement health plans are contributory with participant contributions adjusted annually. Postretirement health and life benefits are funded through a combination of Voluntary Employee Benefit Association trusts (VEBAs), established under section 501(c)(9) of the Internal Revenue Code, and an irrevocable grantor trust. In 2012, $1.5 million was contributed to the VEBAs. In 2011, we contributed $10.9 million to the VEBAs. There were no contributions made to the grantor trust in 2012 and 2011.

Management considers various factors when making funding decisions such as regulatory requirements, actuarially determined minimum contribution requirements, and contributions required to avoid benefit restrictions for the pension plans. Contributions are based on estimates and assumptions which are subject to change. We do not expect to make any contributions to the defined benefit pension plan in 2013. In January 2013, we contributed $4.8 million to the defined benefit postretirement health and life plan, of which $2.0 million was contributed to an irrevocable grantor trust and $2.8 million was contributed to the VEBAs. We do not expect to make any additional contributions to the defined benefit postretirement health and life plan in 2013.

Accounting for defined benefit pension and postretirement benefit plans requires that employers recognize on a prospective basis the funded status of their defined benefit pension and other postretirement plans on their Consolidated Balance Sheet and recognize as a component of other comprehensive income, net of tax, the gains or losses and prior service costs or credits that arise during the period but are not recognized as components of net periodic benefit cost.

The defined benefit pension and postretirement health and life benefit costs recognized annually by our regulated companies are expected to be recovered through rates filed with our regulatory jurisdictions. As a result, these amounts that are required to otherwise be recognized in accumulated other comprehensive income have been recognized as a long-term regulatory asset on our Consolidated Balance Sheet, in accordance with the accounting standards for Regulated Operations. The defined benefit pension and postretirement health and life benefit costs associated with our other non-rate base operations are recognized in accumulated other comprehensive income.

NOTE 15. PENSION AND OTHER POSTRETIREMENT BENEFIT PLANS (Continued)



Pension Obligation and Funded Status
Year Ended December 31	2012			2011
Millions
Accumulated Benefit Obligation		$598.7			$550.6
Change in Benefit Obligation
Obligation, Beginning of Year		$597.5			$525.6
Service Cost	9.1			7.6
Interest Cost	26.4			27.4
Actuarial Loss	38.5			54.6
Benefits Paid	(30.9		)	(28.6		)
Participant Contributions	11.5			10.9
Obligation, End of Year		$652.1			$597.5
Change in Plan Assets
Fair Value, Beginning of Year		$432.4			$382.0
Actual Return on Plan Assets	38.7			33.2
Employer Contribution	19.9			45.8
Benefits Paid	(30.9		)	(28.6		)
Fair Value, End of Year		$460.1			$432.4
Funded Status, End of Year	$(192.0)			$(165.1)

Net Pension Amounts Recognized in Consolidated Balance Sheet Consist of:
Current Liabilities	$(1.1)			$(1.1)
Non-Current Liabilities	$(190.9)			$(164.0)

The pension costs that are reported as a component within our Consolidated Balance Sheet, reflected in long-term regulatory assets and accumulated other comprehensive income, consist of the following:



Unrecognized Pension Costs
Year Ended December 31	2012		2011
Millions
Net Loss		$286.8		$269.0
Prior Service Cost	0.7		1.1
Total Unrecognized Pension Costs		$287.5		$270.1



Components of Net Periodic Pension Expense
Year Ended December 31	2012			2011			2010
Millions
Service Cost		$9.1			$7.6			$6.2
Interest Cost	26.4			27.4			26.2
Expected Return on Plan Assets	(35.4		)	(34.6		)	(33.7		)
Amortization of Loss	17.5			12.1			6.6
Amortization of Prior Service Cost	0.3			0.3			0.5
Net Pension Expense		$17.9			$12.8			$5.8

NOTE 15. PENSION AND OTHER POSTRETIREMENT BENEFIT PLANS (Continued)



Other Changes in Pension Plan Assets and Benefit Obligations Recognized in Other Comprehensive Income and Regulatory Assets
Year Ended December 31	2012			2011
Millions
Net Loss		$35.2			$56.1
Amortization of Prior Service Cost	(0.3		)	(0.3		)
Amortization of Loss	(17.5		)	(12.2		)
Total Recognized in Other Comprehensive Income and Regulatory Assets		$17.4			$43.6



Information for Pension Plans with an Accumulated Benefit Obligation in Excess of Plan Assets
Year Ended December 31	2012		2011
Millions
Projected Benefit Obligation		$652.1		$597.5
Accumulated Benefit Obligation		$598.7		$550.6
Fair Value of Plan Assets		$460.1		$432.4



Postretirement Health and Life Obligation and Funded Status
Year Ended December 31	2012			2011
Millions
Change in Benefit Obligation
Obligation, Beginning of Year		$210.6			$204.1
Service Cost	4.2			3.8
Interest Cost	9.4			10.8
Actuarial Gain	(43.2		)	(2.9		)
Participant Contributions	2.6			2.5
Plan Amendments	(5.3		)	—
Benefits Paid	(9.5		)	(7.7		)
Obligation, End of Year		$168.8			$210.6
Change in Plan Assets
Fair Value, Beginning of Year		$121.0			$114.7
Actual Return on Plan Assets	14.3			—
Employer Contribution	2.3			11.4
Participant Contributions	2.5			2.5
Benefits Paid	(9.1		)	(7.6		)
Fair Value, End of Year		$131.0			$121.0
Funded Status, End of Year	$(37.8)			$(89.6)

Net Postretirement Health and Life Amounts Recognized in Consolidated Balance Sheet Consist of:
Current Liabilities	$(0.8)			$(0.9)
Non-Current Liabilities	$(37.0)			$(88.7)

According to the accounting standards for retirement benefits, only assets in the VEBAs are treated as plan assets in the above table for the purpose of determining funded status. In addition to the postretirement health and life assets reported in the previous table, we had $22.1 million in irrevocable grantor trusts included in Other Investments on our Consolidated Balance Sheet at December 31, 2012 ($20.3 million at December 31, 2011).

NOTE 15. PENSION AND OTHER POSTRETIREMENT BENEFIT PLANS (Continued)

The postretirement health and life costs that are reported as a component within our Consolidated Balance Sheet, reflected in regulatory long-term assets and accumulated other comprehensive income, consist of the following:



Unrecognized Postretirement Health and Life Costs
Year Ended December 31	2012			2011
Millions
Net Loss		$23.5			$78.5
Prior Service Credit	(13.1		)	(9.5		)
Transition Obligation	—			0.1
Total Unrecognized Postretirement Health and Life Costs		$10.4			$69.1



Components of Net Periodic Postretirement Health and Life Expense
Year Ended December 31	2012			2011			2010
Millions
Service Cost		$4.2			$3.8			$4.8
Interest Cost	9.4			10.8			10.9
Expected Return on Plan Assets	(9.9		)	(9.7		)	(9.5		)
Amortization of Prior Service Credit	(1.7		)	(1.7		)	(0.1		)
Amortization of Loss	7.5			8.5			4.8
Amortization of Transition Obligation	0.1			0.1			2.5
Net Postretirement Health and Life Expense		$9.6			$11.8			$13.4



Other Changes in Postretirement Benefit Plan Assets and Benefit Obligations Recognized in Other Comprehensive Income and Regulatory Assets
Year Ended December 31	2012		2011
Millions
Net (Gain) Loss	$(47.5)			$6.9
Prior Service Credit Arising During the Period	(5.3	)	—
Amortization of Prior Service Credit	1.7		1.7
Amortization of Transition Obligation	(0.1	)	(0.1		)
Amortization of Loss	(7.5	)	(8.5		)
Total Recognized in Other Comprehensive Income and Regulatory Assets	$(58.7)		—



Estimated Future Benefit Payments
			Postretirement
	Pension		Health and Life
Millions
2013		$31.2		$7.6
2014		$32.1		$8.2
2015		$33.2		$8.9
2016		$34.4		$9.4
2017		$35.5		$9.7
Years 2018 – 2022		$189.4		$52.0

NOTE 15. PENSION AND OTHER POSTRETIREMENT BENEFIT PLANS (Continued)

The pension and postretirement health and life costs recorded in regulatory long-term assets and accumulated other comprehensive income expected to be recognized as a component of net pension and postretirement benefit costs for the year ending December 31, 2013, are as follows:



	Pension		Postretirement Health and Life
Millions
Net Loss		$21.4		$1.6
Prior Service Cost (Credit)	0.3		(2.5		)
Total Pension and Postretirement Health and Life Cost (Credit)		$21.7	$(0.9)



Weighted-Average Assumptions Used to Determine Benefit Obligation
As of December 31	2012	2011
Discount Rate
Pension	4.10%	4.54%
Postretirement Health and Life	4.13%	4.56%
Rate of Compensation Increase	4.3 - 4.6%	4.3 - 4.6%
Health Care Trend Rates
Trend Rate	9.25%	10%
Ultimate Trend Rate	5%	5%
Year Ultimate Trend Rate Effective	2019	2018



Weighted-Average Assumptions Used to Determine Net Periodic Benefit Costs
Year Ended December 31	2012	2011	2010
Discount Rate	4.54 - 4.56%	5.36 - 5.40%	5.81%
Expected Long-Term Return on Plan Assets
Pension	8.25%	8.5%	8.5%
Postretirement Health and Life	6.6 - 8.25%	6.8 - 8.5%	6.8 - 8.5%
Rate of Compensation Increase	4.3 - 4.6%	4.3 - 4.6%	4.3 - 4.6%

In establishing the expected long-term rate of return on plan assets, we determine the long-term historical performance of each asset class, adjust these for current economic conditions, and utilizing the target allocation of our plan assets, forecast the expected long-term rate of return.

The discount rate is computed using a yield curve adjusted for ALLETE’s projected cash flows to match our plan characteristics. The yield curve is determined using high-quality long-term corporate bond rates at the valuation date. We believe the adjusted discount curve used in this comparison does not materially differ in duration and cash flows from our pension obligation.



Sensitivity of a One-Percentage-Point Change in Health Care Trend Rates
	One Percent		One Percent
	Increase		Decrease
Millions
Effect on Total of Postretirement Health and Life Service and Interest Cost		$2.0	$(1.6)
Effect on Postretirement Health and Life Obligation		$18.2	$(15.1)

NOTE 15. PENSION AND OTHER POSTRETIREMENT BENEFIT PLANS (Continued)



Actual Plan Asset Allocations
	Pension				Postretirement Health and Life (a)
	2012		2011		2012		2011
Equity Securities	54	%	52	%	56	%	51	%
Debt Securities	28	%	27	%	35	%	39	%
Private Equity	13	%	16	%	9	%	10	%
Real Estate	5	%	5	%	—		—
	100	%	100	%	100	%	100	%


(a)	Includes VEBAs and irrevocable grantor trusts.

There were no shares of ALLETE common stock included in pension plan equity securities at December 31, 2012 ($20.0 million, approximately 0.5 million shares, in 2011).

To achieve strong returns within managed risk, we diversify our asset portfolio to approximate the target allocations in the table below. Equity securities are diversified among domestic companies with large, mid and small market capitalizations, as well as investments in international companies. The majority of debt securities are made up of investment grade bonds.



Plan Asset Target Allocations
			Postretirement
	Pension		Health and Life (a)
Equity Securities	52	%	48	%
Debt Securities	30	%	34	%
Real Estate	9	%	9	%
Private Equity	9	%	9	%
	100	%	100	%


(a)	Includes VEBAs and irrevocable grantor trusts.

Fair Value

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price). We utilize market data or assumptions that market participants would use in pricing the asset or liability, including assumptions about risk and the risks inherent in the inputs to the valuation technique. These inputs can be readily observable, market corroborated, or generally unobservable. We primarily apply the market approach for recurring fair value measurements and endeavor to utilize the best available information. Accordingly, we utilize valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs. These inputs, which are used to measure fair value, are prioritized through the fair value hierarchy. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurement) and the lowest priority to unobservable inputs (Level 3 measurement). The three levels of the fair value hierarchy are as follows:

Level 1 — Quoted prices are available in active markets for identical assets or liabilities as of the reported date. Active markets are those in which transactions for the asset or liability occur in sufficient frequency and volume to provide pricing information on an ongoing basis. This category includes various U.S. equity securities, public mutual funds, and futures. These instruments are valued using the closing price from the applicable exchange or whose value is quoted and readily traded daily.

Level 2 — Pricing inputs are other than quoted prices in active markets, but are either directly or indirectly observable as of the reported date. The types of assets and liabilities included in Level 2 are typically either comparable to actively traded securities or contracts, such as treasury securities with pricing interpolated from recent trades of similar securities, or priced with models using highly observable inputs. This category includes various bonds and non-public funds whose underlying investments may be level 1 or level 2 securities.

NOTE 15. PENSION AND OTHER POSTRETIREMENT BENEFIT PLANS (Continued)

Fair Value (Continued)

Level 3 — Significant inputs that are generally less observable from objective sources. The types of assets and liabilities included in Level 3 are those with inputs requiring significant management judgment or estimation, such as the complex and subjective models and forecasts used to determine the fair value. This category includes private equity funds and real estate valued through external appraisal processes. Valuation methodologies incorporate pricing models, discounted cash flow models, and similar techniques which utilize capitalization rates, discount rates, cash flows and other factors.

Pension Fair Value



	Fair Value as of December 31, 2012
Recurring Fair Value Measures	Level 1		Level 2		Level 3		Total
Millions
Assets:
Equity Securities:
U.S. Large-cap (a)		$43.0		$36.0	—			$79.0
U.S. Mid-cap Growth (a)	18.3		15.3		—		33.6
U.S. Small-cap (a)	18.3		15.3		—		33.6
International	50.5		45.9		—		96.4
Debt Securities:
Mutual Funds	72.5		—		—		72.5
Fixed Income	10.4		50.8		—		61.2
Other Types of Investments:
Private Equity Funds	—		—			$58.9	58.9
Real Estate	—		—		24.9		24.9
Total Fair Value of Assets		$213.0		$163.3		$83.8		$460.1

(a)

The underlying investments classified under U.S. Equity Securities consist of money market funds (Level 1) and actively-managed funds (Level 2), which are combined with futures, and settle daily, in a portable alpha program to achieve the returns of the U.S. Equity Securities Large-cap, Mid-cap Growth, and Small-cap funds. Our exposure with respect to these investments includes both the futures and the underlying investments.



Recurring Fair Value Measures
Activity in Level 3	Private Equity Funds			Real Estate
Millions
Balance as of December 31, 2011		$69.0			$21.7
Actual Return on Plan Assets	(9.7		)	3.4
Purchases, sales, and settlements, net	(0.4		)	(0.2		)
Balance as of December 31, 2012		$58.9			$24.9

NOTE 15. PENSION AND OTHER POSTRETIREMENT BENEFIT PLANS (Continued)

Fair Value (Continued)



	Fair Value as of December 31, 2011
Recurring Fair Value Measures	Level 1		Level 2		Level 3		Total
Millions
Assets:
Equity Securities:
U.S. Large-cap (a)		$32.1		$37.3	—			$69.4
U.S. Mid-cap Growth (a)	13.5		15.8		—		29.3
U.S. Small-cap (a)	13.1		15.2		—		28.3
International	—		75.1		—		75.1
ALLETE	21.3		—		—		21.3
Debt Securities:
Mutual Funds	72.8		—		—		72.8
Fixed Income	—		45.5		—		45.5
Other Types of Investments:
Private Equity Funds	—		—			$69.0	69.0
Real Estate	—		—		21.7		21.7
Total Fair Value of Assets		$152.8		$188.9		$90.7		$432.4

(a)



Recurring Fair Value Measures
Activity in Level 3	Equity Securities (ARS)			Private Equity Funds			Real Estate
Millions
Balance as of December 31, 2010		$6.7			$50.7			$20.1
Actual Return on Plan Assets	—			30.9			3.5
Purchases, sales, and settlements, net	(6.7		)	(12.6		)	(1.9		)
Balance as of December 31, 2011	—				$69.0			$21.7

NOTE 15. PENSION AND OTHER POSTRETIREMENT BENEFIT PLANS (Continued)

Fair Value (Continued)

Postretirement Health and Life Fair Value



	Fair Value as of December 31, 2012
Recurring Fair Value Measures	Level 1		Level 2		Level 3		Total
Millions
Assets:
Equity Securities:
U.S. Large-cap (a)		$16.7	—		—			$16.7
U.S. Mid-cap Growth (a)	13.2		—		—		13.2
U.S. Small-cap (a)	13.3		—		—		13.3
International	30.3		—		—		30.3
Debt Securities:
Mutual Funds	25.5		—		—		25.5
Fixed Income	0.2			$18.3	—		18.5
Other Types of Investments:
Private Equity Funds	—		—			$13.5	13.5
Total Fair Value of Assets		$99.2		$18.3		$13.5		$131.0


(a)	The underlying investments classified under U.S. Equity Securities consist of mutual funds (Level 1).



Recurring Fair Value Measures
Activity in Level 3	Private Equity Funds
Millions
Balance as of December 31, 2011		$14.0
Actual Return on Plan Assets	0.2
Purchases, sales, and settlements, net	(0.7		)
Balance as of December 31, 2012		$13.5



	Fair Value as of December 31, 2011
Recurring Fair Value Measures	Level 1		Level 2		Level 3		Total
Millions
Assets:
Equity Securities:
U.S. Large-cap (a)		$15.9	—		—			$15.9
U.S. Mid-cap Growth (a)	11.5		—		—		11.5
U.S. Small-cap (a)	11.2		—		—		11.2
International	25.1		—		—		25.1
Debt Securities:
Mutual Funds	24.1		—		—		24.1
Fixed Income	0.3			$18.9	—		19.2
Other Types of Investments:
Private Equity Funds	—		—			$14.0	14.0
Total Fair Value of Assets		$88.1		$18.9		$14.0		$121.0


(a)	The underlying investments classified under U.S. Equity Securities consist of mutual funds (Level 1).

NOTE 15. PENSION AND OTHER POSTRETIREMENT BENEFIT PLANS (Continued)

Fair Value (Continued)



Recurring Fair Value Measures
Activity in Level 3	Private Equity Funds
Millions
Balance as of December 31, 2010		$12.4
Actual Return on Plan Assets	1.1
Purchases, sales, and settlements, net	0.5
Balance as of December 31, 2011		$14.0

Accounting and disclosure requirements for the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (Act) provide guidance for employers that sponsor postretirement health care plans that provide prescription drug benefits. We provide a fully insured postretirement health benefit, including a prescription drug benefit, which qualifies us for a federal subsidy under the Act. The federal subsidy is reflected in the premiums charged to us by the insurance company.