Pennsylvania Law Weekly
March 13, 2000
The Pension Committee of the Actuarial Standards Board has recently released a standard of practice titled "Actuarial Practice Concerning Retirement Plan Benefits in Domestic Relations Actions." Among other subjects, the standard recommends that future cost of living adjustments be reflected in the valuation, if the plan has a Cost of Living Adjustment. Some of the plans with a COLA are the Civil Service Retirement System, the Armed Forces Retirement System, and the New Jersey Public Employees Retirement System.
The standard goes on to say "it may be appropriate to make an assumption about future ad hoc cost of living adjustments." However, assuming a reasonable cost of living increase is actually very difficult. Looking back over the last 5 years, one could use a "reasonable" cost of living annual increase of 2.5 percent. Even if we assume the next 5 years will look like the last 5, the pension valuation can cover a period of time starting 10 years in the future (if the retirement is in 10 years), then covering approximately 20 years from then, if the employee is a male age 50 with retirement age 60. The present value calculation goes to age 110, the end of the actuarial table.
If we approximate this calculation using life expectancy, we can roughly say that the calculation will cover 20 years after retirement. Why would the last 5 years economically resemble a period of time 10 to 30 years in the future? In fact, the last 5 years have been a period of historically low inflation. Thus, it is highly unlikely that a period of time 10 to 30 years in the future will resemble this period.
Suppose a more scientific approach is used. We can look back over the last 20 years, and find an annual cost of living increase that covers inflation over that entire period of time. But looking back over the last 20 years, inflation has been far from constant. The late `70s and early `80s were a period of high inflation, while inflation has been essentially dropping over the last 20 years, with a few years of increase. Based upon Social Security cost of living increases, the annualized increase in cost of living has been 4.77 percent. This means that the total inflation over the last 20 years would have been the same if inflation had been 4.77 percent each year over the last 20 years. Of course, this did not happen. Inflation was 14 percent in 1980, and has been (almost) steadily dropping.
If this trend continues, inflation over the next 20 years will be much less than 4.77 percent. In fact, inflation will be less than 1 percent, if this trend continues. But this is highly unlikely. The only way that the next 20 years will have an overall annual inflation rate of 4.77 percent is if the next 20 years are a mirror image, in reverse. That is, if inflation turns around at this current minimum and starts increasing over the next 20 years, the next 20 years will have an overall annual inflation rate in the range of 4 to 5 percent. Clearly, looking over the next 20 years, a COLA of 4.77 percent, based upon the last 20 years, is more scientific than using a 2.5 percent COLA based upon the last 5 years. However, even the use of 4.77 percent assumes that the future will be the mirror image of the past. This illustrates just how complex the cost of living issue is in present value calculations.
In Pennsylvania, the Superior Court recognized the problem of using a COLA in a present value calculation. In the Zollars, (579 A.2d 1328, 1990) case, the Superior Court found that the use of a COLA is inappropriate for purposes of immediate offset, since the assumption of future cost of living increase is speculative. The court stated that the use of a COLA is "purely conjecture." Moreover, the court found that including a COLA in a present value calculation can raise the present value to a point where immediate offset is not possible. Thus, the Pennsylvania Superior Court in Zollars recommended the use of a deferred distribution in a case where a COLA is an issue, such as a Civil Service Retirement System pension. Under a deferred distribution, the former spouse will share in any cost of living adjustment that actually occur. This removes speculation about both the COLA and the large lump sum inherent in an immediate offset, since the former spouse will share in the pension on a monthly basis.
However, this solution may not be completely satisfactory. For example, the former spouse may have need of cash as of the time of equitable distribution. Also, the employee may delay retirement, causing an erosion of the present value (note that a government pension is not covered by the Retirement Equity Act, so that an alternate payee must wait until the participant retires in order to commence benefits). Thus, a hybrid solution appears to be the answer in such cases. An immediate offset is based upon a present value without a COLA, and a domestic relation order (COAP, under the CSRS) is used to account for cost of living adjustments.
The following is an example of how this would work Suppose the pension is entirely marital, with an initial benefit of $1,000 per month at retirement. Assuming the equitable distribution is a CSRS COAP, with no immediate offset, and a 50:50 split. If the cost of living adjustment is 3 percent per year, the payments to each party will look like Chart 1.
The alternate payee will share in the COLA, but there is no immediate offset. Supposing that immediate offset is preferable, the way to avoid making an assumption about future cost of living adjustment is the hybrid method. If the present value of the pension is $100,000, without a COLA assumption, the alternate payee can be bought out with a cash payment of $50,000, or by keeping other marital assets worth $50,000. After this offset, the alternate payee has no interest in the non-COLA part of the pension. The COAP will award only a portion of a COLA increase. To "seed" the COAP, the initial payment to the alternate payee will be $1 per year, instead of zero. This is to avoid processing problems with the plan. Thus, the distribution under the COAP will be as outlined in Chart 2.
Thus, the alternate payee will receive 50 percent of each year's cost of living increase. The COAP could be adjusted to compensate for the initial $1 received by the alternate payee, but the language would be extremely cumbersome.
The hybrid method follows the Superior Court's intentions in Zollars, and avoids all speculation about future cost of living adjustments, while providing totally equitable solution that is fair to both parties. The alternate payee will share in exactly the COLA that is actually granted, without speculation or litigation. Others have written about "winning the COLA wars." A war must have a winner and a loser. Using the hybrid method avoids the cost of the "COLA wars" and results in a truly equitable distribution.
Published with permission from Pennsylvania Law Weekly