We describe the primary sources of revenue and categories of expense for each segment below, in our discussion of segment financial results. Management evaluates performance based on segment operating income, which is after deductions for directly related expenses, but not MMC corporate-level expenses. A reconciliation of segment operating income to total operating income is included in Note 17 to the consolidated financial statements included elsewhere in this report. The accounting policies used for each segment are the same as those used for the consolidated financial statements.
During 2005, revenue in the risk and insurance services segment decreased 10% from 2004. Underlying revenue declined 11%, resulting from a $402 million decline in market services revenue, lower levels of new business and renewals and the impact of lower insurance premium rates. These declines were partly offset by the impact of foreign currency exchange rates. Risk consulting & technology revenue increased $541 million. Due to the acquisition of Kroll in July 2004, results in 2005 include, for the first time, a full year of revenue for Kroll, compared with six months of revenue in 2004. Underlying growth in risk consulting & technology was 21%, due to growth in Kroll’s technology services, corporate advisory and restructuring, and background screening businesses. Consulting revenue increased 4%, resulting from a 17% increase in Mercer’s specialty consulting businesses. Investment management revenue declined 12% as a result of the decrease in assets under management and lower investment income.
Putnam receives service fees from the Putnam mutual funds for transfer agent, custody, and other administrative services, as contracted by the Trustees of the Putnam mutual funds. Effective January 2005, the transfer agent service fee agreement was converted to a fixed rate per retail shareholder account and a fixed rate service fee based on average assets under management for mutual fund assets in defined contribution plans. For the first six months of 2004, the transfer agent service fee agreement was based on the reimbursement of the cost of service. For the third and fourth quarters of 2004, transfer agent service fees were based on a fixed fee and recorded as revenue. The change in the service fee agreement resulted in an increase in both service fee revenue and expense of approximately $32 million in 2005 compared with 2004. The change in the service fee contract is expected to have an immaterial impact on operating income in future quarters.
As previously discussed, in January 2005 MMC reached a settlement with the NYAG and NYSID that resolved the actions commenced by them against MMC and Marsh. As a result of this agreement, MMC recorded a charge in 2004 for an $850 million policyholder fund. MMC paid the first $255 million to the fund on June 1, 2005. An additional $255 million must be paid on or before June 1, 2006, and $170 million will be paid to the fund on or before each of June 1, 2007 and 2008, respectively. These amounts are included in Regulatory Settlements in the consolidated balance sheets.
In December 2004, MMC completed financing with respect to a $1.3 billion term loan facility and the amendment of its existing $1 billion revolving credit facility which was scheduled to expire in June 2007 and $700 million revolving credit facility which was scheduled to expire in June 2009. The term loan facility, which was repaid with proceeds from the issuance of the 2005 Notes, was scheduled to mature on December 31, 2006 and replaced revolving credit facilities of $700 million and $355 million, which were scheduled to expire in 2005.
The determination of net periodic pension cost is based on a number of actuarial assumptions, including an expected long-term rate of return on plan assets, the discount rate and assumed rate of salary increase. Significant assumptions used in the calculation of net periodic pension costs and pension liabilities are disclosed in Note 8 to the consolidated financial statements. MMC believes the assumptions for each plan are reasonable and appropriate and will continue to evaluate actuarial assumptions at least annually and adjust them as appropriate. Pension expense in 2005 increased by $130 million compared with 2004. Based on its current assumptions, MMC expects pension expense to decrease by approximately $12 million in 2006 and currently expects to contribute approximately $145 million to the plans during the year.
Reclassifications: Certain reclassifications have been made to the prior year amounts to conform with current year presentation, in particular with regard to segment reclassification resulting from changes in MMC’s organizational structure, discontinued operations classification for Crump and SCMS, the income statement classification of severance related restructuring charges, and the balance sheet classification of certain MMC deferred compensation balances.
The assets and liabilities of the U.K. defined benefit pension plan were re-measured at March 31, 2005 to reflect a plan curtailment as defined by SFAS No. 88, “Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits”. Restructuring activities led to a reduction in force which resulted in the elimination of the accrual for defined benefits for a significant number of employees.
The estimated fair value of options granted without a performance-based triggering event was calculated using the Black-Scholes option pricing valuation model. This model takes into account several factors and assumptions. The risk-free interest rate is based on the yield on U.S. Treasury zero-coupon issues with a remaining term equal to the expected life assumption at the time of grant. The expected life (estimated period of time outstanding) is estimated using the contractual term of the option and the effects of employees’ expected exercise and post-vesting employment termination behavior. Expected volatility prior to July 1, 2005 was calculated based on historical volatility for a period equal to the stock option’s expected life, calculated on a monthly basis. Subsequent to June 30, 2005, MMC began using a blended volatility rate based on the following: (i) volatility derived from daily closing price observations for the 10 year period ended on the valuation date, (ii) implied volatility derived from traded options for the period one week before and one week after the valuation date and (iii) average volatility for the 10 year periods ended on 15 anniversaries prior to the valuation date, using daily closing price observations. The expected dividend yield is based on expected dividends for the expected term of the stock options.
MMC and Putnam have received complaints in over 70 civil actions based on allegations of “market-timing” and, in some cases, “late trading” activities. These actions were filed in courts in various states. All of the actions filed in federal court have been transferred, along with actions against other mutual fund complexes, to the United States District Court for the District of Maryland for coordinated or consolidated pretrial proceedings. The lead plaintiffs in those cases filed consolidated amended complaints on September 29, 2004. MMC and Putnam moved to dismiss the various complaints pending in federal court in Maryland, which are described below:
MMC and Putnam were also named as defendants in a consolidated amended complaint filed on behalf of a putative class of investors in certain Putnam Funds, and in another consolidated amended complaint in which certain fund investors purport to assert derivative claims on behalf of all Putnam Funds. These suits seek to recover unspecified damages allegedly suffered by the funds and their shareholders as a result of purported market-timing and late-trading activity that allegedly occurred in certain Putnam Funds. The derivative suit seeks additional relief, including termination of the investment advisory contracts between Putnam and the funds, cancellation of the funds’ 12b-1 plans and the return of all advisory and 12b-1 fees paid by the funds over a certain period of time. In addition to MMC and
A number of the Putnam Funds have been named as defendants in a purported class action brought on behalf of certain holders of the funds’ Class B shares who either (i) held such shares and were subject to certain contingent deferred sales charges (“CDSCs”) as of October 28, 2003, or (ii) were assessed a CDSC for redeeming such shares on or after October 28, 2003. Plaintiff alleges that Putnam engaged in misconduct constituting a breach of contract and breach of the covenant of good faith and fair dealing with purported class members by allowing market-timing. Plaintiff seeks, among other things, actual damages or statutory damages of $25 for each class member (whichever is greater) and relief from paying a CDSC for redeeming Class B shares. In August 2005, this action was transferred to the consolidated proceedings in the United States District Court for the District of Maryland, described above.