Annual Report 2007

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Notes to the Consolidated Financial Statements

(Dollars in millions, except per-share data and unless otherwise indicated)

We sponsor numerous pension and other post-retirement benefit plans, primarily retiree health, in our U.S. and international operations. September 30 is the measurement date for most of our European plans and December 31 is the measurement date for all of our other post-retirement benefit plans, including all of our domestic plans. Refer to Note 1 – “New Accounting Standards and Accounting Changes” for further information regarding recent accounting changes for our benefit plans. Information regarding our benefit plans is presented below (in millions):


	Pension Benefits						Retiree Health
	2007			2006			2007			2006
Change in Benefit Obligation
Benefit obligation, January 1	$	10,467		$	10,302		$	1,592		$	1,653
Service cost		237			244			17			19
Interest cost		578			732			87			92
Plan participants’ contributions		12			13			20			19
Plan amendments		11			(234	)		–			31
Actuarial gain		(508	)		(85	)		(114	)		(105	)
Currency exchange rate changes		331			564			21			–
Curtailments		(1	)		(2	)		–			–
Benefits paid/settlements		(669	)		(1,067	)		(122	)		(117	)
Benefit obligation, December 31	$	10,458		$	10,467		$	1,501		$	1,592

Change in Plan Assets
Fair value of plan assets, January 1	$	9,217		$	8,444		$	–		$	–
Actual return on plan assets		667			959			–			–
Employer contribution		298			355			102			98
Plan participants’ contributions		12			13			20			19
Currency exchange rate changes		280			513			–			–
Benefits paid/settlements		(669	)		(1,067	)		(122	)		(117	)
Fair value of plan assets, December 31	$	9,805		$	9,217		$	–		$	–

Net funded status (including under-funded and non-funded plans) at December 31	$	(653	)	$	(1,250	)	$	(1,501	)	$	(1,592	)

Amounts recognized in the Consolidated Balance Sheets:
Other long-term assets	$	322		$	19		$	–		$	–
Accrued compensation and benefit costs		(48	)		(79	)		(105	)		(102	)
Pension and other benefit liabilities		(927	)		(1,190	)		–			–
Post-retirement medical benefits		–			–			(1,396	)		(1,490	)
Net amounts recognized	$	(653	)	$	(1,250	)	$	(1,501	)	$	(1,592	)

The pre-tax amounts recognized in accumulated other comprehensive loss consist of:

	Pension Benefits						Retiree Health
	2007			2006			2007			2006
Net actuarial loss	$	1,032		$	1,595		$	169		$	286
Prior service (credit) cost		(213	)		(246	)		11			(1	)
Transition obligation		1			1			–			–
Total	$	820		$	1,350		$	180		$	285

The accumulated benefit obligation for all defined benefit pension plans was $9,748 and $9,589 at December 31, 2007 and 2006, respectively. Information for pension plans with an accumulated benefit obligation in excess of plan assets is presented below (in millions):
	2007			2006
Aggregate projected benefit obligation	$	1,193		$	5,316
Aggregate accumulated benefit obligation		1,109			4,856
Aggregate fair value of plan assets		399			4,133

Our domestic retirement defined benefit plans provide employees a benefit, depending on eligibility, at the greater of (i) the benefit calculated under a highest average pay and years of service formula, (ii) the benefit calculated under a formula that provides for the accumulation of salary and interest credits during an employee’s work life, or (iii) the individual account balance from the Company’s prior defined contribution plan (Transitional Retirement Account or TRA).


	Pension Benefits									Retiree Health
(in millions)	2007			2006			2005			2007			2006			2005
Components of Net Periodic Benefit Cost
Defined benefit plans
Service cost	$	237		$	244		$	234		$	17		$	19		$	20
Interest cost ⁽¹⁾		578			732			581			87			92			90
Expected return on plan assets ⁽²⁾		(668	)		(802	)		(622	)		–			–			–
Recognized net actuarial loss		75			104			98			10			19			31
Amortization of prior service credit		(20	)		(18	)		(3	)		(12	)		(13	)		(24	)
Recognized net transition obligation (asset)		–			2			1			–			–			–
Recognized curtailment/settlement loss		33			93			54			–			–			–
Net periodic benefit cost		235			355			343			102			117			117
Defined contribution plans		80			70			71			–			–			–
Total	$	315		$	425		$	414		$	102		$	117		$	117

Other Changes in Plan Assets and Benefit Obligations Recognized in Other Comprehensive Income:
Net actuarial loss (gain)		(499	)								(114	)
Prior service cost (credit)		5									–
Amortization of net actuarial (loss) gain		(108	)								(10	)
Amortization of prior service (cost) credit		20									12
Total recognized in other comprehensive income ⁽³⁾		(582	)								(112	)
Total Recognized in Net Periodic Benefit Cost and Other Comprehensive Income	$	(267	)							$	(10	)

(1) Interest cost includes interest expense on non-TRA obligations of $374, $340, and $328 and interest expense directly allocated to TRA participant accounts of $204, $392, and $253 for the years ended December 31, 2007, 2006 and 2005, respectively.

(2) Expected return on plan assets includes expected investment income on non-TRA assets of $464, $410, and $369 and actual investment income on TRA assets of $204, $392, and $253 for the years ended December 31, 2007, 2006 and 2005, respectively.

(3) Amount represents the pre-tax effect included within other comprehensive income. The net of tax amount and effect of translation adjustments are included within the Consolidated Statements of Common Shareholders’ Equity.

The net actuarial loss and prior service credit for the defined benefit pension plans that will be amortized from accumulated other comprehensive loss into net periodic benefit cost over the next fiscal year are $38 and $(21), respectively. The net actuarial loss and prior service credit for the other defined benefit postretirement plans that will be amortized from accumulated other comprehensive loss into net periodic benefit cost over the next fiscal year are $2 and $(12) respectively.

Pension plan assets consist of both defined benefit plan assets and assets legally restricted to the TRA accounts. The combined investment results for these plans, along with the results for our other defined benefit plans, are shown above in the actual return on plan assets caption. To the extent that investment results relate to TRA, such results are charged directly to these accounts as a component of interest cost.

Plan Amendment

During 2006 we amended one of our domestic defined benefit pension plans. The amendment changed the process of calculating benefits for certain employees who retire from or leave the Company after 2012. The new process ensures that certain benefit enhancements are only provided to plan participants who qualify to receive them based on age and years of service at termination. The prior process for years after 2012 provided some plan participants with these benefit enhancements regardless of qualification. The amendment resulted in a net decrease of $173 in the Projected Benefit Obligation and a net decrease of $20 in the Accumulated Benefit Obligation. The amendment also decreased net periodic pension benefit cost by $31 for the full year 2006.

Plan Assets

Current Allocation and Investment Targets: As of the 2007 and 2006 measurement dates, the global pension plan assets were $9.8 billion and $9.2 billion, respectively. These assets were invested among several asset classes. None of the investments include debt or equity securities of Xerox Corporation. The amount and percentage of assets invested in each asset class as of December 31, 2007 and 2006 is shown below:


	Asset Value				Percentage of Total Assets
(in millions)	2007		2006		2007		2006
Asset Category
Equity securities	$	5,060	$	4,971	52	%	54	%
Debt securities		3,973		3,319	40		36
Real estate		720		728	7		8
Other		52		199	1		2
Total	$	9,805	$	9,217	100	%	100	%

Investment Strategy: The target asset allocations for our worldwide plans for 2007 were 50% invested in equities, 42% invested in fixed income, 7% invested in real estate and 1% invested in Other. The target asset allocations for our worldwide plans for 2006 were 53% invested in equities, 39% invested in fixed income, 7% invested in real estate and 1% invested in Other. The pension assets outside of the U.S. as of the 2007 and 2006 measurement dates were $5.7 billion and $5.1 billion, respectively.

The target asset allocations for the U.S. pension plan include 60% invested in equities, 35% in fixed income and 5% in real estate. Cash investments are sufficient to handle expected cash requirements for benefit payments and will vary throughout the year. The expected long-term rate of return on the U.S. pension assets is 8.75%.

We employ a total return investment approach whereby a mix of equities and fixed income investments are used to maximize the long-term return of plan assets for a prudent level of risk. The intent of this strategy is to minimize plan expenses by exceeding the interest growth in long-term plan liabilities. Risk tolerance is established through careful consideration of plan liabilities, plan funded status, and corporate financial condition. This consideration involves the use of long-term measures that address both return and risk. The investment portfolio contains a diversified blend of equity and fixed income investments. Furthermore, equity investments are diversified across U.S. and non-U.S. stocks as well as growth, value and small and large capitalizations. Other assets such as real estate, private equity, and hedge funds are used to improve portfolio diversification. Derivatives may be used to hedge market exposure in an efficient and timely manner; however, derivatives may not be used to leverage the portfolio beyond the market value of the underlying investments. Investment risks and returns are measured and monitored on an ongoing basis through annual liability measurements and quarterly investment portfolio reviews.

Expected Long Term Rate of Return: We employ a “building block” approach in determining the long-term rate of return for plan assets. Historical markets are studied and long-term relationships between equities and fixed income are assessed. Current market factors such as inflation and interest rates are evaluated before long-term capital market assumptions are determined. The long-term portfolio return is established giving consideration to investment diversification and rebalancing. Peer data and historical returns are reviewed periodically to assess reasonableness and appropriateness.

Contributions: We expect to contribute approximately $130 to our worldwide defined benefit pension plans and approximately $100 to our other post retirement benefit plans in 2008. The 2008 expected pension plan contributions do not include any planned contribution for our domestic tax-qualified defined benefit plans because there are no required contributions to these plans for the 2008 fiscal year. However, once the January 1, 2008 actuarial valuations and projected results as of the end of the 2008 measurement year are available, the desirability of additional contributions will be reassessed. Based on these results, we may voluntarily decide to contribute to these plans, even though no contribution is required. In 2007 and 2006, after making this assessment, we contributed $158 and $228, respectively, to our domestic tax qualified plans to make them 100% funded on a current liability basis under the ERISA funding rules.

Estimated Future Benefit Payments: The following benefit payments, which reflect expected future service, as appropriate, are expected to be paid during the following years (in millions):


	Pension Benefits		Retiree Health
2008		$ 732		$ 105
2009		645		114
2010		675		119
2011		690		123
2012		758		127
Years 2013-2017		3,977		635


	Pension Benefits						Retiree Health
	2007		2006		2005		2007		2006		2005
Weighted-average assumptions used to determine benefit obligations at the plan measurement dates
Discount rate	5.9	%	5.3	%	5.2	%	6.2	%	5.8	%	5.6	%
Rate of compensation increase	4.1		4.1		3.9		–	⁽¹⁾	–	⁽¹⁾	–	⁽¹⁾

(1) Rate of compensation increase is not applicable to the retiree health benefits as compensation levels do not impact earned benefits.


	Pension Benefits								Retiree Health
	2008		2007		2006		2005		2008		2007		2006		2005
Weighted-average assumptions used to determine net periodic benefit cost for years ended December 31
Discount rate	5.9	%	5.3	%	5.2	%	5.6	%	6.2	%	5.8	%	5.6	%	5.8	%
Expected return on plan assets	7.6		7.6		7.8		8.0		–	⁽¹⁾	–	⁽¹⁾	–	⁽¹⁾	–	⁽¹⁾
Rate of compensation increase	4.1		4.1		3.9		4.0		–	⁽²⁾	–	⁽²⁾	–	⁽²⁾	–	⁽²⁾

(1) Expected return on plan assets is not applicable to retiree health benefits as these plans are not funded.

(2) Rate of compensation increase is not applicable to retiree health benefits as compensation levels do not impact earned benefits.


	2007		2006
Health care cost trend rate assumed for next year	10.4	%	9.9	%
Rate to which the cost trend rate is assumed to decline (the ultimate trend rate)	5.0	%	5.2	%
Year that the rate reaches the ultimate trend rate	2013		2011

Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans. A one-percentage-point change in assumed health care cost trend rates would have the following effects (in millions):


	One-percentage-point increase		One-percentage-point decrease
Effect on total service and interest cost components	$ 7		$ (5		)
Effect on post-retirement benefit obligation		86		(73	)

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