8. Retirement Plans and Other Benefits

Pinnacle West sponsors a qualified defined benefit and account balance pension plan (The Pinnacle West Capital Corporation Retirement Plan) and a non-qualified supplemental excess benefit retirement plan for the employees of Pinnacle West and its subsidiaries. All new employees participate in the account balance plan. Defined benefit plans specify the amount of benefits a plan participant is to receive using information about the participant. The pension plan covers nearly all employees. The supplemental excess benefit retirement plan covers officers of the Company and highly compensated employees designated for participation by the Board of Directors. Our employees do not contribute to the plans. Generally, we calculate the benefits based on age, years of service and pay.

Pinnacle West also sponsors another postretirement benefit plan (Pinnacle West Capital Corporation Group Life and Medical Plan) for the employees of Pinnacle West and its subsidiaries. This plan provides medical and life insurance benefits to retired employees. Employees must retire to become eligible for these retirement benefits, which are based on years of service and age. For the medical insurance plan, retirees make contributions to cover a portion of the plan costs. For the life insurance plan, retirees do not make contributions. We retain the right to change or eliminate these benefits.

Pinnacle West uses a December 31 measurement date each year for its pension and other postretirement benefit plans. The market-related value of our plan assets is their fair value at the measurement date. See Note 14 for discussion of how fair values are determined. Due to subjective and complex judgments, which may be required in determining fair values, actual results could differ from the results estimated through the application of these methods.

A significant portion of the changes in the actuarial gains and losses of our pension and postretirement plans is attributable to APS and therefore is recoverable in rates. Accordingly, these changes are recorded as a regulatory asset. In its 2009 retail rate case settlement, APS received approval to defer a portion of pension and other postretirement benefit cost increases incurred in 2011 and 2012. We deferred pension and other postretirement benefit costs of approximately $14 million in 2012 and $11 million in 2011. Pursuant to an ACC regulatory order, we began amortizing the regulatory asset over 3 years beginning in July 2012. We amortized approximately $4 million during 2012.

On March 23, 2010, the President signed into law comprehensive health care reform legislation under the Patient Protection and Affordable Care Act (the “Act”). One feature of the Act is the elimination of the tax deduction for prescription drug costs that are reimbursed as part of the Medicare Part D subsidy. Although this tax increase does not take effect until 2013, we are required to recognize the full accounting impact in our financial statements in the period in which the Act is signed. In accordance with accounting for regulated companies, the loss of this deduction is substantially offset by a regulatory asset that will be recovered through future electric revenues. In the first quarter of 2010, Pinnacle West charged regulatory assets for a total of $42 million, with a corresponding increase in accumulated deferred income tax liabilities, to reflect the impact of this change in tax law.

The following table provides details of the plans’ net periodic benefit costs and the portion of these costs charged to expense (including administrative costs and excluding amounts capitalized as overhead construction, billed to electric plant participants or charged to the regulatory asset) (dollars in thousands):

	Pension									Other Benefits
	2012			2011			2010			2012			2011			2010
Service cost-benefits earned during the period	$	63,502		$	57,605		$	59,064		$	27,163		$	21,856		$	19,236
Interest cost on benefit obligation	119,586			124,727			122,724			46,467			46,807			42,428
Expected return on plan assets	(140,979		)	(133,678		)	(124,161		)	(45,793		)	(41,536		)	(39,257		)
Amortization of:
Transition obligation	—			—			—			452			452			452
Prior service cost (credit)	1,143			1,400			1,705			(179		)	(179		)	(539		)
Net actuarial loss	44,250			25,956			18,833			20,233			15,015			10,317
Net periodic benefit cost	$	87,502		$	76,010		$	78,165		$	48,343		$	42,415		$	32,637
Portion of cost charged to expense	$	36,333		$	29,312		$	37,933		$	19,321		$	15,208		$	15,839

The following table shows the plans’ changes in the benefit obligations and funded status for the years 2012 and 2011 (dollars in thousands):

	Pension						Other Benefits
	2012			2011			2012			2011
Change in Benefit Obligation
Benefit obligation at January 1	$	2,699,126		$	2,345,060		$	1,047,094		$	827,897
Service cost	63,502			57,605			27,163			21,856
Interest cost	119,586			124,727			46,467			46,807
Benefit payments	(113,632		)	(104,257		)	(26,279		)	(24,877		)
Actuarial (gain) loss	82,264			275,991			(104,027		)	171,674
Plan amendments	—			—			—			3,737
Benefit obligation at December 31	2,850,846			2,699,126			990,418			1,047,094

Change in Plan Assets
Fair value of plan assets at January 1	1,850,550			1,775,596			608,663			567,410
Actual return on plan assets	259,363			162,042			83,567			58,367
Employer contributions	65,000			—			22,707			18,769
Benefit payments	(95,732		)	(87,088		)	(30,716		)	(35,883		)
Fair value of plan assets at December 31	2,079,181			1,850,550			684,221			608,663
Funded Status at December 31	$	(771,665	)	$	(848,576	)	$	(306,197	)	$	(438,431	)

The following table shows the projected benefit obligation and the accumulated benefit obligation for pension plans with an accumulated obligation in excess of plan assets as of December 31, 2012 and 2011 (dollars in thousands):

	2012		2011
Projected benefit obligation	$	2,850,846	$	2,699,126
Accumulated benefit obligation	2,646,306		2,396,575
Fair value of plan assets	2,079,181		1,850,550

The following table shows the amounts recognized on the Consolidated Balance Sheets as of December 31, 2012 and 2011 (dollars in thousands):

	Pension						Other Benefits
	2012			2011			2012			2011
Current liability	$	(19,107	)	$	(18,097	)	$	—		$	—
Noncurrent liability	(752,558		)	(830,479		)	(306,197		)	(438,431		)
Net amount recognized	$	(771,665	)	$	(848,576	)	$	(306,197	)	$	(438,431	)

The following table shows the details related to accumulated other comprehensive loss as of December 31, 2012 and 2011 (dollars in thousands):

	Pension						Other Benefits
	2012			2011			2012			2011
Net actuarial loss	$	644,239		$	724,605		$	238,862		$	400,892
Prior service cost (credit)	3,169			4,312			(475		)	(655		)
Transition obligation	—			—			—			452
APS’s portion recorded as a regulatory asset	(550,471		)	(632,099		)	(230,020		)	(390,521		)
Income tax benefit	(38,303		)	(38,243		)	(2,585		)	(3,296		)
Accumulated other comprehensive loss	$	58,634		$	58,575		$	5,782		$	6,872

The following table shows the estimated amounts that will be amortized from accumulated other comprehensive loss and regulatory assets into net periodic benefit cost in 2012 (dollars in thousands):

	Pension		Other Benefits
Net actuarial loss	$	37,574	$	12,236
Prior service cost (credit)	1,097		(179		)
Total amounts estimated to be amortized from accumulated other comprehensive loss and regulatory assets in 2013	$	38,671	$	12,057

The following table shows the weighted-average assumptions used for both the pension and other benefits to determine benefit obligations and net periodic benefit costs:

	Benefit Obligations As of December 31,				Benefit Costs For the Years Ended December 31,
	2012		2011		2012		2011		2010
Discount rate-pension	4.01	%	4.42	%	4.42	%	5.31	%	5.90	%
Discount rate-other benefits	4.20	%	4.59	%	4.59	%	5.49	%	6.00	%
Rate of compensation increase	4.00	%	4.00	%	4.00	%	4.00	%	4.00	%
Expected long-term return on plan assets	N/A		N/A		7.75	%	7.75	%	8.25	%
Initial health care cost trend rate	7.50	%	7.50	%	7.50	%	8.00	%	8.00	%
Ultimate health care cost trend rate	5.00	%	5.00	%	5.00	%	5.00	%	5.00	%
Number of years to ultimate trend rate	4		4		4		4		4

In selecting the pretax expected long-term rate of return on plan assets we consider past performance and economic forecasts for the types of investments held by the plan. For the year 2013, we are assuming a 7.0% long-term rate of return on plan assets, which we believe is reasonable given our asset allocation in relation to historical and expected performance.

Assumed health care cost trend rates above have a significant effect on the amounts reported for the health care plans. In selecting our health care trend rates, we consider past performance and forecasts of health care costs. A one percentage point change in the assumed initial and ultimate health care cost trend rates would have the following effects (dollars in millions):

	1% Increase		1% Decrease
Effect on other postretirement benefits expense, after consideration of amounts capitalized or billed to electric plant participants	$	14	$	(11	)
Effect on service and interest cost components of net periodic other postretirement benefit costs	17		(13		)
Effect on the accumulated other postretirement benefit obligation	172		(136		)

Plan Assets

The Board of Directors has delegated oversight of the pension and other postretirement benefit plans’ assets to an Investment Management Committee (“Committee”). The Committee has adopted investment policy statements (“IPS”) for the pension and the other postretirement benefit plans’ assets. The investment strategies for these plans include external management of plan assets, and prohibition of investments in Pinnacle West securities.

The overall strategy of the pension plan’s IPS is to achieve an adequate level of trust assets relative to the benefit obligations. To achieve this objective, the plan’s investment policy provides for mixes of investments including long-term fixed income assets and return-generating assets. The target allocation between return-generating and long-term fixed income assets is defined in the IPS and is a function of the plan’s funded status. The plan’s funded status is reviewed on at least a monthly basis.

Long-term fixed income assets, also known as liability-hedging assets, are designed to offset changes in the benefit obligations due to changes in interest rates. Long-term fixed income assets consist primarily of fixed income debt securities issued by the U.S. Treasury, other government agencies, and corporations. Long-term fixed income assets may also include interest rate swaps, U.S. Treasury futures and other instruments.

Return-generating assets are intended to provide a reasonable long-term rate of investment return with a prudent level of volatility. Return-generating assets are composed of U.S. equities, international equities, and alternative investments. International equities include investments in both developed and emerging markets. Alternative investments primarily include investments in real estate, but may also include private equity and various other strategies. The plan may hold investments in return-generating assets by holding securities in common and collective trusts.

Based on the IPS, and given the pension plan’s funded status at year-end 2012, the long-term fixed income assets and the return generating assets each had a target allocation of 50%. The return-generating assets have additional target allocations, as a percent of total plan assets, of 30% equities in U.S. and other developed markets, 6% equities in emerging markets, and 14% in alternative investments. The pension plan IPS does not provide for a specific mix of long-term fixed income assets, but does expect the average credit quality of such assets to be investment grade. As of December 31, 2012, long-term fixed income assets represented 44% of total pension plan assets, and return-generating assets represented 56% of total pension plan assets.

The asset allocation for other postretirement benefit plan assets is governed by the IPS for those plans, which provides for an asset allocation target mix of at least 25% of fixed income assets and 55% or less of non-fixed income assets. This asset allocation target mix does not vary with the plan’s funded status. As of December 31, 2012, investment in fixed income assets represented 45% of the other postretirement benefit plan total assets, and non-fixed income assets represent 55% of the other postretirement benefit plan’s assets. Fixed income assets are primarily invested in corporate bonds of investment-grade U.S. issuers, and U.S. Treasuries. Non-fixed income assets are primarily invested in large cap U.S. equities in diverse industries, and international equities in both emerging and developed markets.

See Note 14 for a discussion on the fair value hierarchy and how fair value methodologies are applied. The plans invest directly in fixed income and equity securities, in addition to investing indirectly in equity securities and real estate through the use of common and collective trusts. Equity securities held directly by the plans are valued using quoted active market prices from the published exchange on which the equity security trades, and are classified as Level 1. Fixed income securities issued by the U.S. Treasury held directly by the plans are valued using quoted active market prices, and are classified as Level 1. Fixed income securities issued by corporations, municipalities, and other agencies are primarily valued using quoted inactive market prices, or quoted active market prices for similar securities, or by utilizing calculations which incorporate observable inputs such as yield, maturity and credit quality. These instruments are classified as Level 2.

The common and collective trusts, which are similar to mutual funds, are maintained by banks or investment companies and hold certain investments in accordance with a stated set of objectives (such as tracking the performance of the S&P 500 index). The common and collective equity trusts are valued using the concept of net asset value (“NAV”), which is a value derived from the quoted active market prices of the underlying securities. The plans’ common and collective real estate trust is valued using NAV, which is derived from the appraised values of the trust’s underlying real estate assets. As of December 31, 2012 the plans were able to transact in the common and collective trusts at NAV and accordingly classify these investments as Level 2. Because the trust’s shares are offered to a limited group of investors, they are not considered to be traded in an active market.

The plans’ trustee provides valuation of our plan assets by using pricing services that utilize methodologies described to determine fair market value. We have internal control procedures to ensure this information is consistent with fair value accounting guidance. These procedures include assessing valuations using an independent pricing source, verifying that pricing can be supported by actual recent market transactions, assessing hierarchy classifications, comparing investment returns with benchmarks, and obtaining and reviewing independent audit reports on the trustee’s internal operating controls and valuation processes.

The fair value of Pinnacle West’s pension plan and other postretirement benefit plan assets at December 31, 2012, by asset category, are as follows (dollars in thousands):

	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)			Other (c)			Balance at December 31, 2012
Pension Plan:
Assets:
Cash and cash equivalents	$	579	$	—	$	—		$	—		$	579
Fixed Income Securities:
Corporate	—		607,749		—			—			607,749
U.S. Treasury	232,161		—		—			—			232,161
Other (b)	—		67,992		—			—			67,992
Equities:
U.S. Companies	531,291		—		—			—			531,291
International Companies	43,848		—		—			—			43,848
Common and collective trusts:
U.S. Equities	—		176,694		—			—			176,694
International Equities	—		271,735		—			—			271,735
Real estate	—		117,854		—			—			117,854
Short-term investments and other	—		26,922		2,419		(a)	(63		)	29,278

Total Pension Plan	$	807,879	$	1,268,946	$	2,419		$	(63	)	$	2,079,181
Other Benefits:
Assets:
Cash and cash equivalents	$	60	$	—	$	—		$	—		$	60
Fixed Income Securities:
Corporate	—		163,306		—			—			163,306
U.S. Treasury	112,558		—		—			—			112,558
Other (b)	—		33,998		—			—			33,998
Equities:
U.S. Companies	205,714		—		—			—			205,714
International Companies	14,412		—		—			—			14,412
Common and collective trusts:
U.S. Equities	—		60,038		—			—			60,038
International Equities	—		76,969		—			—			76,969
Real Estate	—		9,378		—			—			9,378
Short-term investments and other	402		6,340		—			1,046			7,788

Total Other Benefits	$	333,146	$	350,029	$	—		$	1,046		$	684,221

(a) Represents investments in a partnership that invests in privately held portfolio companies.

(b) This category consists primarily of debt securities issued by municipalities.

The fair value of Pinnacle West’s pension plan and other postretirement benefit plan assets at December 31, 2011, by asset category, are as follows (dollars in thousands):

	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Other (a)		Balance at December 31, 2011
Pension Plan:
Assets:
Cash and cash equivalents	$	1,441	$	—	$	—	$	1,441
Fixed Income Securities:
Corporate	—		584,619		—		584,619
U.S. Treasury	207,862		—		—		207,862
Other (b)	—		62,906		—		62,906
Equities:
U.S. Companies	436,393		—		—		436,393
International Companies	118,263		—		—		118,263
Common and collective trusts:
U.S. Equities	—		139,321		—		139,321
International Equities	—		156,407		—		156,407
Real estate	—		106,147		—		106,147
Short-term investments and other	—		29,913		7,278		37,191

Total Pension Plan	$	763,959	$	1,079,313	$	7,278	$	1,850,550
Other Benefits:
Assets:
Cash and cash equivalents	$	160	$	—	$	—	$	160
Fixed Income Securities:
Corporate	—		148,417		—		148,417
U.S. Treasury	103,321		—		—		103,321
Other (b)	—		30,105		—		30,105
Equities:
U.S. Companies	179,235		—		—		179,235
International Companies	22,486		—		—		22,486
Common and collective trusts:
U.S. Equities	—		52,507		—		52,507
International Equities	—		53,504		—		53,504
Real Estate	—		8,446		—		8,446
Short-term investments and other	—		8,516		1,966		10,482

Total Other Benefits	$	305,202	$	301,495	$	1,966	$	608,663

(a) Represents plan receivables and payables.

(b) This category consists primarily of debt securities issued by municipalities.

The following table shows the changes in fair value for assets that are measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the year ended December 31, 2012 (dollars in thousands):

Short-Term Investments and Other	Pension
Beginning balance at January 1, 2012	$	—
Actual return on assets still held at December 31, 2012	(668		)
Purchases, sales, and settlements	3,087
Transfers in and/or out of Level 3	—
Ending balance at December 31, 2012	$	2,419

Contributions

We made contributions to our pension plan totaling $65 million in 2012, zero in 2011 and $200 million in 2010. The minimum contributions for the pension plan due in 2013, 2014 and 2015 under the recently enacted Moving Ahead for Progress in the 21st Century Act (MAP-21) are estimated to be zero, $89 million and $112 million, respectively. We expect to make voluntary contributions totaling $140 million to the pension plan in 2013, and contributions up to approximately $175 million in each of 2014 and 2015. With regard to contributions to our other postretirement benefit plans, we made a contribution of approximately $23 million in 2012, $19 million in 2011, and $17 million in 2010. The contributions to our other postretirement benefit plans for 2013, 2014 and 2015 are expected to be approximately $20 million each year. APS and other subsidiaries fund their share of the contributions. APS’s share of the pension plan contribution was $64 million in 2012, zero in 2011, and $195 million in 2010. APS’s share of the contributions to the other postretirement benefit plan was $22 million in 2012, $19 million in 2011, and $16 million in 2010.

Estimated Future Benefit Payments

Benefit payments, which reflect estimated future employee service, for the next five years and the succeeding five years thereafter are estimated to be as follows (dollars in thousands):

Year	Pension		Other Benefits
2013	$	126,091	$	26,934
2014	135,602		29,870
2015	145,438		32,929
2016	155,774		35,893
2017	165,535		38,765
Years 2018-2022	971,362		235,170

Electric plant participants contribute to the above amounts in accordance with their respective participation agreements.

Employee Savings Plan Benefits

Pinnacle West sponsors a defined contribution savings plan for eligible employees of Pinnacle West and its subsidiaries. In 2012, costs related to APS’s employees represented 99% of the total cost of this plan. In a defined contribution savings plan, the benefits a participant receives result from regular contributions participants make to their own individual account, the Company’s matching contributions and earnings or losses on their investments. Under this plan, the Company matches a percentage of the participants’ contributions in cash which is then invested in the same investment mix as participants elect to invest their own future contributions. Pinnacle West recorded expenses for this plan of approximately $8 million for 2012, $8 million for 2011 and $9 million for 2010.