Notes to consolidated financial statements (audited)

International Business Machines Corporation and Subsidiary Companies

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V. Retirement-related benefits (audited)

IBM offers defined benefit pension plans, defined contribution plans, as well as nonpension postretirement plans primarily consisting of retiree medical benefits. These benefits form an important part of the company’s total compensation and benefits program that is designed to attract and retain highly skilled and talented employees. The company and its subsidiaries have defined benefit and/or defined contribution plans that cover substantially all regular employees, and supplemental retirement plans that cover certain executives. In addition, the company has certain U.S. and non-U.S. nonpension postretirement benefit plans that provide medical and dental benefits to certain retirees and their eligible dependents.

IBM provides U.S. regular, full-time and part-time employees hired prior to January 1, 2005 with noncontributory defined benefit pension benefits via the IBM Personal Pension Plan (PPP). The PPP consists of a tax qualified plan and a non-tax qualified (non-qualified) plan. The qualified plan is funded by company contributions to an irrevocable trust fund, which is held for the sole benefit of participants and beneficiaries. The non-qualified plan, which provides benefits in excess of Internal Revenue Service limitations for qualified plans, is unfunded. The number of individuals receiving benefit payments from the PPP at December 31, 2005 and 2004 was 137,106 and 139,804, respectively.

Benefits provided to employees under this plan are calculated using benefit formulas that vary based on the participant. Pension benefits are calculated using one of two methods based upon specified criteria used to determine each participant’s eligibility. The first method uses a five year, final pay formula that determines benefits based on salary, years of service, mortality and other participant-specific factors. The second method is a cash balance formula that calculates benefits using a percentage of employees’ annual salary, as well as an interest crediting rate.

In December 2005, the company approved a plan amendment which provides that benefits under the PPP will stop accruing for active participants effective December 31, 2007.

The company also has a non-qualified U.S. Supplemental Executive Retention Plan (SERP). The SERP, which is unfunded, provides defined benefit pension benefits in addition to the PPP to eligible executives based on average earnings, years of service and age at retirement. Effective July 1, 1999, the company adopted the SERP (which replaced the previous Supplemental Executive Retirement Plan). Some participants of the prior SERP will still be eligible for benefits under that prior plan if those benefits are greater than the benefits provided under the new plan. Certain former partners of PwCC also participate in the SERP under two separate benefit formulas. The number of individuals receiving benefit payments under this plan were 354 and 309 as of December 31, 2005 and 2004, respectively.

In December 2005, the company also approved an amendment to the SERP which provides that no further benefits will accrue effective December 31, 2007.

U.S. regular, full-time and part-time employees are eligible to participate in the IBM Savings Plan, which is a tax-qualified defined contribution plan under section 401(k) of the Internal Revenue Code. For employees hired prior to January 1, 2005, the company matches 50 percent of the employee’s contribution up to the first 6 percent of the employee’s eligible compensation. For employees hired or rehired after December 31, 2004 who have also completed one year of service, the company matches 100 percent of the employee’s contribution up to the first 6 percent of eligible compensation. All contributions, including the company match, are made in cash, in accordance with the participants’ investment elections. There are no minimum amounts that must be invested in company stock, and there are no restrictions on transferring amounts out of the company’s stock to another investment choice. The number of employees receiving distributions under this plan were 2,786 and 2,659 as of December 31, 2005 and 2004, respectively.

In January 2006, the company announced its intention to amend the plan effective January 1, 2008. The announced change will consist of two components including an automatic contribution for all eligible U.S. employees and an increase in the amount of company matching contribution for all eligible U.S. employees hired on or before December 31, 2004.

The company also maintains an unfunded, non-qualified, defined contribution plan, the IBM Executive Deferred Compensation Plan (EDCP), which allows eligible executives to defer compensation, and to receive company matching contributions under the applicable IBM Savings Plan formula (depending on the date of hire as described above), with respect to amounts in excess of IRS limits for tax-qualified plans. Amounts contributed to the plan as a result of deferred compensation, as well as company matching contributions are recorded as liabilities. Deferred compensation amounts may be directed by participants into an account that replicates the return that would be received had the amounts been invested in similar IBM Savings Plan investment options. Company matching contributions, which are provided in the “Plan Financial Information” section, are directed to participant accounts and appreciate or depreciate each reporting period based on changes in the company’s stock price. The total participants receiving benefit payments under this plan were 384 and 356 as of December 31, 2005 and 2004, respectively.

The company has a defined benefit nonpension postretirement plan that provides medical and dental benefits for eligible U.S. retirees and eligible dependents, as well as life insurance for eligible U.S. retirees. Effective July 1, 1999, the company established a “Future Health Account” (FHA) for employees who were more than five years away from retirement eligibility. Employees who were within five years of retirement eligibility are covered under the company’s prior retiree health benefits arrangements. Under either the FHA or the prior retiree health benefit arrangements, there is a maximum cost to the company for retiree health benefits. For employees who retired before January 1, 1992, that maximum became effective in 2001. For all other employees, the maximum is effective upon retirement. Effective January 1, 2004, the company amended its nonpension postretirement plan to provide that new hires, as of that date or later, will no longer be eligible for company subsidized benefits. As of December 31, 2005 and 2004, the total participants receiving benefit payments under this plan were 115,921 and 113,716, respectively.

Most subsidiaries and branches outside the United States have defined benefit and/or defined contribution plans that cover substantially all regular employees. The company deposits funds under various fiduciary-type arrangements, purchases annuities under group contracts or provides reserves for these plans. Benefits under the defined benefit plans are typically based either on years of service and the employee’s compensation (generally during a fixed number of years immediately before retirement) or on annual credits. The range of assumptions that are used for the non-U.S. defined benefit plans reflects the different economic environments within various countries.

In addition, certain of the company’s non-U.S. subsidiaries have defined benefit nonpension postretirement plans that provide medical and dental benefits for eligible non-U.S. retirees and eligible dependents as well as life insurance for certain eligible non-U.S. retirees. However, most of the retirees outside the United States are covered by government sponsored and administered programs.

The company accounts for its defined benefit pension plans and its nonpension postretirement benefit plans in accordance with the provisions of the applicable GAAP, which requires the company to record its obligation to the participants as well as the corresponding net periodic cost. The company determines its obligation to the participants and its net periodic cost principally using actuarial valuations provided by third-party actuaries.

The amount that the company records in its Consolidated Statement of Financial Position is reflective of the total projected benefit obligation (PBO), the fair value of plan assets and any deferred gains or losses at the measurement date. The company uses a December 31 measurement date for the majority of its pension plans and nonpension postretirement plans. The PBO is the actuarial present value of benefits expected to be paid upon retirement based upon estimated future compensation levels. The fair value of plan assets represents the current market value of cumulative company contributions made to an irrevocable trust fund, held for the sole benefit of participants, which are invested by the trust. Deferred gains or losses arise as a result of events that impact the plan and affect current and future net periodic cost/(income), as permitted by accounting standards. Examples of such “events” include plan amendments and changes in actuarial assumptions such as discount rate, rate of compensation increases and mortality.

The principle underlying recognition of income/expense is that employees render service over their service lives on a relatively smooth basis and therefore, the income statement effects of pensions or nonpension postretirement benefit plans are earned in, and should follow, the same pattern. The amount of net periodic cost/(income) that is recorded in the Consolidated Statement of Earnings consists of several components including service cost, interest cost, expected return on plan assets, and amortization of previously unrecognized gains or losses. Service cost represents the value of the benefits earned in the current year by the participants. Interest cost represents the time value of money cost associated with the passage of time. In addition, the net periodic cost/(income) is impacted by the anticipated income/loss from the return on invested assets as well as the income/expense resulting from the recognition of previously deferred items. Certain items such as changes in employee base, plan changes and changes in actuarial assumptions have resulted in deferral of the income/expense impact of such events. Accounting standards require the use of an attribution approach which generally spreads income/expense of the deferred items over the service lives of the employees in the plan, provided such amounts exceed thresholds which are based upon the obligation or the value of plan assets. The average service lives of the employees in the PPP currently approximates 11 years and vary for employees in non-U.S. plans.

Underlying both the calculation of the PBO and net periodic cost/(income) are actuarial valuations, as discussed above. These valuations reflect the terms of the plans and use participant-specific information such as salary, age and years of service as well as certain assumptions which include estimates of discount rates, expected return on plan assets, rate of compensation increases and mortality rates. For additional information regarding assumptions, see the section in this footnote entitled “Assumptions Used to Determine Plan Financial Information.”

As noted above, the PBO is the actuarial present value of benefits expected to be paid upon retirement based upon future compensation levels. The accumulated benefit obligation (ABO) is the present value of the actuarially determined company obligation for pension payments, assuming no further salary increases for employees. For instances in which the fair value of plan assets are less than the ABO, as of the measurement date (defined as an unfunded ABO position), a minimum liability equal to this difference is recognized in the Consolidated Statement of Financial Position. The offset to the minimum liability results in establishing an intangible asset not exceeding unrecognized prior service cost. Any remaining offsetting amount results in a net of tax charge to the Accumulated gains and (losses) not affecting retained earnings section of Stockholders’ Equity in the Consolidated Statement of Financial Position.

The company records expense for defined contribution plans for the company’s matching contribution when the employee renders service to the company, essentially coinciding with the cash contributions to the plans.

The following table presents a summary of the total retirement-related benefit plan cost/(income) included in the Consolidated Statement of Earnings:

The following table presents a summary of the total projected benefit obligation, fair value of plan assets and the associated asset/(liability) position included in the Consolidated Statement of Financial Position:

The following represents financial information for the company’s significant (1) defined benefit pension and (2) nonpension post retirement plans. The significant defined benefit pension plans primarily consist of the qualified portion of the IBM PPP in the U.S. and the material non-U.S. pension plans. The material non-U.S. pension plans include plans in the following countries: Germany, the United Kingdom, Japan, the Netherlands, Canada, Switzerland, Brazil and Spain. The significant nonpension postretirement benefit plan represents the U.S. nonpension postretirement plan.

The following table presents the components of net periodic pension cost/(income):

The changes in the benefit obligations and plan assets of the defined benefit pension and nonpension postretirement benefit plans as of December 31, 2005 and 2004 were:

In December 2005, the company approved amendments to the PPP and the SERP which provided that active participants will no longer accrue benefits under these plans effective December 31, 2007. As a result of this action, the company recorded a curtailment charge of approximately $267 million in the Consolidated Statement of Earnings for the year ended December 31, 2005. In addition, the company recorded a reduction in the PBO balances of approximately $775 million and $13 million at December 31, 2005 for the PPP and the SERP, respectively.

In addition, in December 2005, the company amended the IBM Japan Pension Plan, which the company considers one of its material non-U.S. pension plans. This amendment modified certain plan terms including a change in the method of calculating benefits for certain participants at December 31, 2005. This amendment did not impact net periodic cost/(income), however, the amendment resulted in a $561 million reduction to the PBO as of December 31, 2005.

The overall change in the Net prepaid pension asset balance from 2004 to 2005 of approximately $500 million was caused by an increase in the prepaid pension asset related to the PPP as of December 31, 2005, principally due to a $1.7 billion contribution made by the company in January 2005 which increased the fair value of plan assets. In addition, a portion of the overall increase in the prepaid pension asset in the PPP was driven by the reduction of the PBO as a result of the plan amendment that caused the curtailment charge previously discussed. The reduction in the material non-U.S. plan prepaid pension asset was driven principally by the reduction in the PBO related to the amendments made to the IBM Japan Pension Plan. The increase in the company’s Prepaid pension asset balance from 2003 to 2004 was primarily due to a $700 million contribution made by the company to the PPP during 2004.

Underlying both the calculation of the PBO and net periodic cost/(income) are actuarial valuations. These valuations use participant-specific information such as salary, age and years of service as well as certain assumptions, the most significant of which include: estimates of discount rates, expected return on plan assets, rate of compensation increases, interest crediting rates and mortality rates. The company evaluates these assumptions, at a minimum, annually, and makes changes as necessary.

Following is information on assumptions which had a significant impact on net periodic cost/(income) and the year-end benefit obligations for defined benefit pension plans and nonpension postretirement benefit plans were as follows: