Learn About Pensions

Pension Valuation Tutorial

By: Mark K. Altschuler, Actuary

This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional services. If legal advice or other professional assistance is required, the services of a competent professional person should be sought.

From a Declaration of Principles jointly adopted by a committee of the American Bar Association and a Committee of Publishers and Associations

Reprinted with permission. 2007, Aspen Publishers, Inc., from Valuing Specific Assets in Divorce, edited by Robert D. Feder. All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopy, recording, or any information storage and retrieval system, without permission is writing from the publisher.

Table of Contents

16.01    Introduction
16.02    Immediate Offset
16.03    Deferred Distribution
16.04    Glossary of Pension Terms
16.05    Documents Needed for Pension Valuation or Distribution
16.06    Common Pension Issues
16.07    Early Retirement Incentives
16.08    Cost of Living Adjustments
16.09    Retirement Age
16.10    Cut-off Date and Marital Coverture Fraction
16.11    Benefit Commencement and Termination
16.12    Valuation Strategies
16.13    Calculation of Present Value of a Defined Benefit Pension

Introduction

For many years, pensions were a reward for long and faithful service, at the discretion of the employer, and not guaranteed or funded. In 1972, Congress passed the Employee Income Retirement Security Act (ERISA), which subjected pensions to government regulation. In particular, a company's contributions to a plan, and the earnings on those contributions, became tax-free under ERISA as long as the plan maintains tax-favorable status.

The two primary types of pensions are defined contribution and defied benefit plans. Under a defined benefit plan, the pension is defined by a formula and usually payable as a monthly annuity until the participant's death. In a defined contribution plan, the individual's pension is in the form of an individual account balance. A common type of defined contribution plan is a 401(k). Under such a plan, employees may defer compensation, and the employer makes a contribution to the plan on the employee's behalf. These contributions are excluded from the employee's gross income in the year they are made and are not subject to taxation until distributed to the employee, usually at normal retirement age. If the employee terminates before normal retirement age, he or she may take the distribution as early as the plan's earliest retirement age. However, the distribution is subject to a 10 percent penalty, as well as taxes, if taken before age 55, unless the employee is disabled (as defined in Internal Revenue Code (IRC) 72(m)(7)).

There are two main classes of pension plans, those subject to ERISA and those that are not subject to ERISA. Generally speaking, all private pension plans are subject to ERISA. These are corporate and multi-employer union pension plans. Government plans (federal, state, and local) are not subject to ERISA. Quasi-governmental plans, such as state public school teachers' plans, are also not subject to ERISA. See Exhibit 16-1.

EXHIBIT 16-1 Types of Pension Plans

  ERISA Non-ERISA  
  Corporate Government  
  Union Public Schools   
    Military  

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16.02 Immediate Offset

Under immediate offset a present value is determined for the pension and the nonemployee spouse receives offsetting assets of comparable value (e.g., the marital residence). The present value of a pension is the lump sum, which if invested at the assumed interest rate used in the calculation (called the discount rate), would be sufficient to pay the required monthly pension. Section 16.14 explains the mechanics of the present value calculation.

The present value concept is based on the time value of money. One dollar invested in a bank today is worth approximately $1.03 one year after the date of the deposit, assuming a 3 percent annual interest rate. Therefore, an individual would pay $1.00 today for the right to have $1.03 one year from now. This is the essence of a present value calculation. The calculation determines what an individual would pay today for the guarantee of a certain payment in the future. A pension is a promise or contract by the employer with the employee to pay a specified monthly benefit beginning at early or normal retirement age. In a defined benefit plan, the pension benefit typically is calculated based on a formula using the number of years of the employee's service and his historical pay levels~ The present value of that pension is what an individual would pay today to have the right to receive that pension. In order to determine the present value, one has to discount the future payments for interest - e.g., 3 percent per year in the above example. The pension expert has to select an appropriate interest rate. Also, the expert has to factor in the anticipated mortality of the employee. Pension benefits are normally paid for the lifetime of the employee. Therefore, the employee's mortality determines how many years of pension payments he will receive. Finally, the expert has to determine the marital or community component of the pension benefit, which is the portion acquired during the marriage. This is done by the use of the marital coverture fraction, which is explained in further detail in 16.10.

What follows is an example of a present value calculation by a pension expert in a divorce case. See Exhibit 16-2.

EXHIBIT 16-2   Pension Valuation Report

DATE: March 5, 1998
PREPARED FOR: Robert D. Feder, Attorney At Law
NAME OF EMPLOYEE: Paul Aspen
EMPLOYER: Doe Industries, Inc.
PLAN: Pension Plan (Defined Benefit)
 
Birth Date:
Entry Date:
Marriage Date:
Cut-off Date:
Valuation Date:
03/05/48
01/01/68
01/01/68
03/05/98
03/05/98
Retirement Age: 65
Retirement Date: 04/01/13
Status: Active
Sex: Male
Age: 50
 
  1. Accrued monthly pension at cut-off date
  2. GATT annuity factor
  3. Present value (12 x item 1 x item 2)
  4. Length of Plan service while married
  5. Length of Plan service to cut-off date
  6. Coverture fraction (item 4 divided by item 5)
  7. Marital present value (item 3 x item 6)
  8. Marital employee contributions/account
  9. Marital present value as of valuation date
    (greater of item 7 or item 8)
$1,000
3.681
44,172
30.16667
30.16667
1.00000
44,172
0

$44,172
Marital portion contingent on jurisdictional cut-off date.
Pension form: Life Annuity
Calculations in accordance with generally accepted actuarial standards
Interest rate: 6.00%          Mortality: GAM-83 Table

The interest and mortality factors are combined into an annuity factor (item number 2 in Exhibit 16-2). The accrued monthly benefit (multiplied by 12x) is multiplied by the annuity factor for interest and mortality and that amount is multiplied by the coverture fraction to determine the marital or community present value. If the marital or community employee contributions exceed the marital/community present value, then the contributions would be the relevant value, but that is rarely the case. Very often defined benefit plans have no contribution.


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16.03 Deferred Distribution

The nonemployee spouse is awarded a piece of the employee's pension when that pension becomes payable, hence the word "deferred." In an ERISA plan, this is at the employee's earliest retirement age. Some ERISA defined contribution plans have been amended to allow the distribution immediately instead of waiting until the employee's earliest retirement age

.

Defined contribution plans allow for the transfer of a lump sum from the employee's plan interest to the other spouse's IRA (referred to as an IRA rollover) or a cash payment to the other spouse, since the pension is in the form of an individual account balance. Some defined benefit plans also allow for the transfer of a lump sum to the nonemployee spouse.

A deferred distribution or lump sum transfer is usually accomplished by a qualified domestic relations order (QDRO). The word "qualified" refers to a plan being qualified under ERISA. Therefore, strictly speaking, the term "QDRO" refers to ERISA plans only. However, non-ERISA plans, such as the federal Civil Service Retirement System, recognize court orders similar to a QDRO that attach a component of a member's pension for the benefit of a former spouse.

The Retirement Equity Act of 1984 (REA) created rights for the former spouse. REA is the federal statute that created the QDRO. REA also created rights for a current spouse that did not exist under ERISA. Under REA, a married employee must choose a joint and survivor annuity at retirement so that, in the case of the death of the participant, the surviving spouse will receive no less than 50 percent of the monthly payment or annuity paid while the participant was alive. REA also states that under a QDRO, the former spouse (known as the alternate payee) shall be treated as a surviving spouse for both pre-retirement and postretirement death benefits, regarding the portion of the pension that is divided under the QDRO. Since a current spouse must be provided a death benefit, a former spouse also has the right to a death benefit under a QDRO, so that benefits continue after the death of the participant. In fact, as discussed in 16.09, the logic of REA with respect to QDROs allows a plan to create a pension payable over the alternate payee's lifetime, independent of the life of the participant. In this way, the death of the participant after retirement has no effect on the alternate payee's benefits. This type of division of pension benefits is often referred to as a "separate interest benefit." If the alternate payee's benefit is tied to the life of the participant, it is called a "piggyback, or shared interest benefit."

Divorce counsel must decide whether the immediate offset or deferred distribution QDRO approach is the best for his or her client in each case. The initial consideration is what liquid assets or cash are available to the spouses. If the employee spouse lacks the initial resources to buyout the nonemployee spouse's interest in his pension with offsetting assets, a QDRO will usually be necessary.


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16.04 Glossary of Pension Terms

Exhibit 16-3 is a glossary of terms used in pension valuation and distribution.


EXHIBIT 16-3   Glossary of Pension Valuation Terms

Accrued Benefit:Portion of ultimate benefit earned as of certain date.
Alternate Payee:Former spouse awarded a component of a participant's pension under a QDRO.
Benefit:DB = monthly pension; DC = account balance.
Contribution:DB = employer pays; DC = employer and sometimes employee pays.
COLA:Cost of Living Adjustment; yearly increase in a pension benefit, tied to the consumer price index. Common in government plans, but very rare in private pension plans.
Coverture Fraction:Fractional portion of benefit attributable to marriage. Sometimes defined as length of time from date of marriage or date employment commenced if after date of marriage to date of marital separation divided by total years of employment through the current date.
Cutoff Date:The point in time after which the nonemployee spouse has no claim on the additional pension benefits earned by the employee. Varies from jurisdiction to jurisdiction.
DB:Defined benefit pension plan, formula benefit, no individual accounts.
DC:Defined contribution plan, all individual accounts, no specific benefit.
Deferred Distribution:Delayed payment of pension to divorced spouse, usually pursuant to a QDRO.
Early Retirement:Retirement with a reduced pension before normal retirement.
Early Retirement Enhancement:Retirement before normal retirement age, when the pension in unreduced, slightly reduced, or a bonus is added to the pension.
ERISA:Employee Retirement Income Security Act; Act of Congress subjecting private pension plans to federal regulation, establishing tax-free status in plans that conform to ERISA.
Immediate Offset:Approach whereby pension's present value is determined and offset against other asset given to nonemployee spouse (e.g., marital home).
Normal Retirement Age:Age to receive full, unreduced pension.
PBGC:Pension Benefit Guaranty Corporation; insures most DB plans.
QDRO:Qualified domestic relations order for plan to pay divorced spouse.
REA:Retirement Equity Act; Act of Congress that amended ERISA, providing for QDROs (exception to the anti-alienation rule in ERISA).
Valuation Date:Computation date base for present value, usually current date.
Value:Present worth of a future pension, or present account balance.


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16.05 Documents Needed for Pension Valuation or Distribution

Whether the choice is immediate offset or deferred distribution, counsel needs to obtain the following documents and information regarding the employee's pension:

  1. Obtain authorization from the plan participant early in the case, in order to obtain needed information directly from the plan administrator.
  2. A copy of the plan booklet, known as the summary plan description, or SPD.
  3. Any supplements containing plan amendments, known as summary of material modifications, or SMM.
  4. If the plan is defined benefit, a benefit statement showing the benefit accrued as of a certain date, payable at normal retirement. The date may be the cutoff date in the jurisdiction, or the current date, depending upon case law in the jurisdiction. The issue of cutoff date versus current date will be explained in detail later in this Introduction.
  5. In certain cases, such as employee termination, the benefit statement showing the benefit payable at early retirement may be appropriate. If the employee has actually taken early retirement, the early retirement statement is needed.
  6. If the plan is defined contribution, the account statements from the cutoff date to the valuation date. These statements are used to calculate the earnings on the account. If the hire date is before the marriage, the account statement as of the date of marriage is needed. In some jurisdictions, all the statements during the marriage are needed.
  7. If warranted by the size or complexity of the plan, it may be advisable to obtain the formal plan document, which may run anywhere from a few pages to over 100 pages. This is usually needed to prepare a thorough QDRO.
  8. Every private defined benefit pension plan, and most non-ERISA plans, have an actuarial valuation report for the plan. This report lists the aggregate assets and liabilities of the plan, and may list the participants with their accrued and projected pension benefits and their individual present values, as viewed by the plan's actuary. However, an individual's present value in the report may not be appropriate for property distribution purposes. The plan's actuary may have used a set of composite actuarial assumptions for the plan in total but not for anyone individual.
  9. The plan may prepare a present value calculation for an employee under the assumption of plan termination. Divorce counsel may want to use this value. However, the plan's assumptions may not be appropriate for calculating the marital value of the pension. The benefit used is unlikely to be the benefit accrued at the cutoff date, nor will a coverture fraction be applied.
  10. Account statements showing any loan balances, the dates and amounts of the loans taken out, and the dates and amounts of any repayments.
  11. Any standard form QDRO prepared by the employer. However, be advised that many standard QDROs may not meet a client's needs. A well-informed pension consultant can usually tailor a QDRO for a client and secure its approval, so long as the QDRO does not require a plan amendment.
  12. Any company booklets with respect to employee benefits and QDROS.

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16.06 Common Pension Issues

Once divorce counsel has identified whether the pension plan in question is an ERISA or non-ERISA plan, and whether immediate offset or deferred distribution is the best approach in the particular case, a number of additional issues must be considered. 1These issues include:
  1. Early retirement incentives;
  2. Cost of living adjustments (COLAs);
  3. Retirement age;
  4. Marital coverture fraction;
  5. Benefit commencements and terminations; and 6. Offsets to the accrued benefit.

1 If the pension is defined contribution and counsel uses a deferred distribution approach, these factors are not relevant. The nonemployee spouse receives a lump sum payment either as an outright cash payment or a rollover into his or her IRA. The nonemployee spouse receives a specific dollar amount that he or she can reinvest. Counsel should consider interest on the lump sum amount if payment is not received in a timely fashion. Does the lump sum consist of cash or securities? If securities, pick high tax basis securities to minimize future taxes, pick undervalued stock and securities purchased with plan contributions which have already been taxed.


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16.07 Early Retirement Incentives

For immediate offset, present value purposes, a pension's present value may double if the actuary uses the employee's early retirement age rather than normal retirement age. Since the benefit at early retirement is payable over many more years than the benefit at normal retirement, the monthly benefit must be reduced to compensate. However, this reduction is often less than the reduction needed to keep the present value the same. This is called a subsidized reduction. Thus, the present value using early retirement age can be much greater than the present value assuming normal retirement. In addition, there may be special early retirement enhancements that further lessen the reduction. In any given year, about 10 to 15 percent of large companies offer early retirement incentives. Typically, the percentage is higher in recession years and lower in "boom" (full employment) years. As part of an early retirement incentive, there may be a special early retirement enhancement. Typically, this is accomplished by adding 5 or 10 years to the employee's actual age, making the employee mathematically closer to the normal retirement age. Another way companies enhance a pension as part of an early retirement incentive is to credit the employee with additional years of service, and/or create a supplemental annuity until the employee reaches age 62 (the earliest age for Social Security payments).

The legislative history of REA indicates that an early retirement subsidy may be shared by the alternate payee, if taken by the participant. Reported case decisions from New York2 and California3 have found that the alternate payee should share in early retirement subsidies.4 The California court in Oddino found that the alternate payee would not share in the subsidy if the participant has not yet retired. This reasoning follows IRC 414(P)(4)(A)(ii), which states that QDRO benefits are payable to the alternate payee before the participant retires, at the participant's earliest retirement age, without taking into account any early retirement subsidy if the participant has not yet retired. In the New York case, Olivo, the court found that special early retirement supplements that did not exist at the time of the divorce were not marital property. However, the enhancement to the basic pension was found to be marital property. Many state courts have struggled with whether these subsidies are or are not marital property.5


2 Olivo v. Olivo, 624 N.E.2d 151,604 N.Y.S. 2d 23 (1993).

3 Oddino v. Oddino, 939 P.2d 1266, 65 Cal. RptT. 2d 566 (1997), cert. denied. 1185 S. Ct. 1302 (1.998).

4 See also Lehman v. Lehman, SO 26850, Cal., May 28, 1998 and Reinbold v. Reinbold, 710 A.2d 556, N.J. Super. App. Div. 1998.

5 See Gordon v. Gordon, 545 Pa. 391,681 A.2d 732 (1996). For a detailed discussion of the case law across the country, see Feder, R., Valuation Strategies in Divorce, 4th ed., 15.56, Aspen Law and Business, New York, NY, 1997.


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16.08 Cost of Living Adjustments

Many non-ERISA plans provide cost of living adjustments or COLAs. ERISA plans are not as generous as government plans, and rarely have COLAs. Chapter 19 on Fortune 500 company pensions will illustrate just how much more generous the federal Civil Service Retirement System (CSRS) is in comparison to Fortune 500 company plans. Even without the COLA, the CSRS pension has a much higher present value. Sometimes, COLAs are given in ERISA plans on an ad hoc basis, but not every year. Non-ERISA plans that have annual COLAs base the COLA on the consumer price index. If the actuary includes the COLA in his or her present value calculation for immediate offset purposes, this leads to a much higher present value. Some states allow for the COLA to be included in the pension valuation, 6 while other states do not? Even if the COLA is included, no one knows what inflation will be many years from now, and a competent pension valuator will illustrate a range of COLAs. The employee's attorney should strongly resist including the COLA as a benefit that is too speculative to include in the pension calculation. This issue could be resolved by a QDRO or QDRO type order that gives the alternate payee a pro-rata share of the COLA, if any. The CSRS and military pensions are not qualified under ERISA and do not use QDROs. The QDRO equivalent for CSRS is called a Court Order Available for Processing (COAP). The military order is called a Military Court Order (MCO).


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16.09 Retirement Age

Under REA, ERISA plans allow the alternate payee to commence benefits as early as the participant's earliest retirement age even if the participant is not actually receiving pension benefits yet and has not retired This guarantees that the alternate payee's benefit under a QDRO will have the same value as an immediate offset, at least under certain conditions. See *19.04 for further discussion of this issue. Essentially, the QDRO "purchases" an annuity for the alternate payee. The purchase price is the cash payment under the immediate offset approach that he or she is foregoing, in return for getting the QDRO award. However, non-ERISA plans are not governed by REA. Thus, the alternate payee must wait until the participant commences benefits in order to receive his or her benefits. If the participant delays retirement, his or her own retirement benefit will increase, due to increasing service and salary, but the alternate payee's present value will be decreased, due to delay in payment. Thus, the DRO and the immediate offset approach will not be equivalent. The value of the "purchased" annuity will be less than the "purchase price," or the cash payment under the immediate offset approach. The alternate payee loses value every year the participant delays retirement. In California, this issue has been settled by that state's Supreme Court in the case of Cornejo v. Cornejo.8 In that case, the participant was a public school teacher in a non-ERISA plan. Thus, the alternate payee could not commence benefits until the participant retired. The Supreme Court of California found that if the participant delays retirement, the alternate payee must receive an immediate cash payment equal to the present value of his or her award as of the participant's normal retirement age. Many states do not have case law covering this situation. This issue may be addressed in the QDRO or QDRO-type order, and will be discussed in detail in Chapter 17 on the CSRS system. However, unless this issue is addressed, the best strategy for the nonemployee spouse is to obtain an immediate offset. The caveat is that the COLA may not be included in an immediate offset, depending on the case law of the particular state. Thus, if the case law of the state includes a COLA in an immediate offset, or if the plan has no COLA (e.g.. various state, municipal, and public school teachers' plans have no COLA), the best strategy for the nonemployee spouse in a non-ERISA plan is to choose immediate offset.


6 E.g.. New Jersey, Hayden v. Hayden, 284 N.J. Super. 418, 665 A.2d 772 (1995).

7 E.g.. Pennsylvania, Zollars v. Zollars, 397 Pa. Super. 204, 579 A.2d 1328, (1990). 16-12

8 916 P.2d 476,53 Cat. Rptr. 2d 81 (1996).


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16.10 Cut-off Date and Marital Coverture Fraction

Whether ERISA or non-ERISA, the QDRO (or DRO) must state whether the alternate payee receives a portion of the benefit accrued as of a certain cut-off date or as of the participant's retirement date. The cutoff date is the point in time when the marriage ended, after which the nonemployee spouse has no further claim on assets earned by the employee. The cut-off date varies from jurisdiction to jurisdiction. In Pennsylvania, Oregon, and Maryland, the cut-off date is the date of marital separation. In New Jersey, it is the date the divorce complaint is filed of record. In New York, it is the date of service of the divorce complaint. In Florida, the cut-off date is the date of the final judgment of dissolution. In California and Colorado, the cut-off date is the date of divorce.9

The cut-off date is the date when the employee's pension benefits are stopped for purposes of calculating the other spouse's marital or community benefit. Benefits accrued after the cut-off date are excluded from any distribution to the alternate payee. However, there is a second step in determining the marital component of the pension in addition to the cut-off date for the accrued benefit. This step is called the marital coverture fraction. This fraction is used to insure that the alternate payee's claim is limited to the portion of the pension benefit acquired during the years of the marriage and excludes nonmarital years, such as years of service prior to marriage. The numerator in the fraction is the years of marital service. Marital service is service from the later of the date of hire or date of marriage, to the cut-off date.10 Different fractions are used in different states. If the cut-off date benefit is used, the denominator is total service up to the cut-off date. If the retirement date benefit is used, the denominator is total years of service. With the same numerators, the coverture fraction at retirement date is smaller than at the separation date, because the denominator is larger using a retirement date. Some states are vague about using the cut-off date or retirement date. Other states, such as Pennsylvania,11 Florida,12 and Maryland,13 use the cut-off benefit. In Virginia, the use of the cut-off benefit (date of separation in Virginia) is statutory.14 In Ohio, New York and Arkansas, the retirement date benefit and coverture fraction is used. 15Many states leave this issue open.

In New Jersey, the cut-off date benefit is used in present value calculations, while the retirement date benefit is used in QDROs. Most states that use the retirement date in QDROs use the current accrued benefit in pension valuations. Typically, states using the cut-off date benefit in pension valuations use the cut-off date benefit in QDROs. New Jersey is an exception.

Suppose the case law in a given jurisdiction holds that the nonemployee spouse is entitled to 50 percent of the benefit accrued during the marriage. The strategy for the nonemployee spouse is to argue that the retirement date benefit should be used, and that the use of the coverture fraction "separates out" the marital component. The nonemployee spouse should further argue that use of the benefit as of the date of divorce (or other cut-off date) does not protect the nonemployee spouse from inflation.

The strategy for the employee spouse is to argue that the increase in the benefit from the cut-off date until the retirement date is due to salary increases in addition to inflation, contributions to the plan and promotions, all due to post-marriage efforts of the employee spouse. Thus, the employee spouse will argue for use of the cut-off date benefit. In general, the retirement date benefit, multiplied by the coverture fraction at retirement, is greater than the cut-off date benefit, multiplied by the coverture fraction at the cut-off date. This is because the coverture fraction decreases as a function of time only, while the benefit increases as a function of time and salary in defined benefit plans, plus contributions, and earnings on those contributions in a defined contribution plan.


9 See James v. James, 950 P.2d 624, Co. Ct. of App., 1997.

10 One exception is in the state of Oregon, where the beginning date is the later of the date of hire or date of cohabitation. Troffo v. Troffo, 151 Or. App. 741, 951 P.2d 197 (1997).

11 Berrington v. Berrington, 534 Pa. 393, 633 A.2d 589 (1993).

12 Boyett v. Boyett, 703 So. 2d 451 (1997).

13 Quinn v. Quinn, 83 Md. App. 460, 575 A.2d 764 (1990).

14 Code of Virginia, 20-107.3 (G).

15 Hoyt v. Hoyt, 53 Ohio St. 3d 177, 559 N.E.2d 1292 (1990); Majauskas v. Majauskas, 61 N.Y. 2d 481,463 N.E.2d IS (1984); Brown v. Brown, 332 Ark. 235, 962 S.W.2d 810 (1998).


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16.11 Benefit Commencement and Termination

A QDRO needs to specify when benefits start and stop. In an ERISA plan, benefits may start at the participant's earliest retirement date, whether or not the participant has retired. Counsel should be aware that there will be an actuarial reduction for use of the early retirement date for the alternate payee. Benefits may start no later than the date of the participant's actual retirement. Theoretically, a separate interest QDRO could allow the alternate payee to commence benefits after the participant. However, almost all plans require that the alternate payee commence benefits no later than the participant. The QDRO should specify what happens in the case of the death of the participant, before and after retirement. The QDRO should specify what happens in the case of the death of the alternate payee, both before and after the alternate payee's benefits commence. In each case, the death of the alternate payee may be before or after the death of the participant Divorce counsel should take these contingencies into account Note that the answers will depend on whether the plan is an ERISA or non-ERISA plan, a separate interest or shared interest, and the specific agreement between the parties. Key questions include:

  1. Before/after retirement, what happens if the participant dies first, before/after he begins receiving his pension benefits?
  2. What happens if the alternate payee dies before the participant and before he retires and begins receiving his benefits? Are the alternate payee's benefits forfeited and do the benefits revert back to the participant?
  3. If the alternate payee dies first before the participant retires, but she has begun receiving benefits, can she leave her benefits to her beneficiary upon her death?
  4. If the participant dies rust, the alternate payee receives benefits, and then dies, can she leave her benefits to her beneficiaries upon her death?

Different pension plans provide different answers to these questions, but divorce counsel should address each of these issues in any QDRO or QDRO-type order.


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16.12 Valuation Strategies

Depending on the characteristics and provisions in a particular pension plan with respect to all of the factors discussed above, the employee and nonemployee spouse may be better or worse off with an immediate offset or deferred distribution approach. Counsel should consider various valuation strategies to maximize the client's position. For example, if the nonemployee spouse needs upfront cash as part of his or her property distribution and there are no available early retirement enhancements or subsidies in the plan, then immediate offset is the best approach because the nonemployee spouse receives the cash he or she needs without losing early retirement enhancements with a deferred distribution. If the pension plan will allow the employee to delay retirement indefinitely, as does the federal Civil Service Retirement System, then an immediate offset approach may be better for the alternate payee so he or she is not subject to that delay. An alternative is to draft the QDRO type order to remove the financial incentive for the participant to delay retirement by increasing the benefit to the alternate payee for each year that the participant delays. The present value of the alternate payee's benefit remains the same, and the participant no longer profits by his or her delay. A specific explanation and illustration of this approach can be found in Chapter 17.

With respect to early retirement subsidies, the alternate payee's counsel should negotiate for the inclusion of a provision whereby the alternate payee receives a pro-rata share of that subsidy. Obviously, the participant's counsel should object. Much depends on the case law in the particular jurisdiction. However, if the jurisdiction's case law allows the alternate payee to receive a share of the subsidy, it would be a mistake for divorce counsel to fail to include such a provision in the QDRO. The same analysis applies with respect to COLAs. If a jurisdiction allows the alternate payee's participation in the COLA in the QDRO, then divorce counsel should include such a provision in the QDRO. The COLA should be less objectionable because that is an increase to the pension benefit that is awarded across the board to all employees based on an inflation index and has nothing to do with the specific work efforts of the employee after divorce. This may not be the case with early retirement incentives or enhancements. For example, the employee may need to reach a threshold number of years of service to earn an early retirement subsidy. If the employee has worked, for example, 17 years through the date of separation and does not earn the early retirement subsidy until he works three additional post-separation years, should the nonemployee spouse benefit from that early retirement subsidy which was earned, in part, with post-separation service? The nonemployee's counsel should argue that 17 out of the 20 years of service were earned during the marriage and the employee could not have earned the subsidy without those 17 marital years. A reasonable compromise would be to prorate the early retirement subsidy so that seventeen/twentieths (17/20) of the benefit is community or marital property subject to division between the spouses. Often, it is not clear whether the subsidy was earned with marital or post-marital years of service. What if the company announces an early retirement subsidy in the year following the divorce and the subsidy is awarded without regard to years of service? The employee spouse will argue the benefit did not exist at the time of the divorce and the nonemployee spouse should receive no portion of that subsidy. The nonemployee spouse will argue that the subsidy is not being granted because of any work effort by the employee during or after the marriage, but that this is an across-the-board increase in pension benefits. Since she is receiving a percentage of the pension benefits under the existing QDRO, she should receive the same percentage of the newly enhanced benefit. These are some of the more difficult valuation strategies that can arise in a divorce case. The facts and circumstances of each case must be carefully scrutinized in light of the existing legal precedent in the jurisdiction. There is not always a simple answer or solution for each case. That is why many pension disputes have been litigated to the states' highest courts.

These considerations and decisions are summarized in the flow charts in Exhibit 16-4A (ERISA plans) and Exhibit 16-4B (Non-ERISA plans). Subsequent chapters address the specifics of a variety of specialized pension plans, such as Fortune 500 company plans (e.g., Sun Oil Co. and SmithKline Beecham), the federal Civil Service Retirement System, and the military retirement system.

EXHIBIT 16-4A QDRO Flow Chart for ERISA Plans



Legend
CF = Coverture Fraction
Imm. Off. = Immediate Offset
cutoff ben = benefit accrued at cutoff date
ret ben = benefit accrued at retirement
ER = early retirement
AP = Alternate Payee
P = Participant
REA = Retirement Equity Act


EXHIBIT 16-4B QDRO Flow Chart for Non-ERISA Plans



Legend
CF = Coverture Fraction
Imm. Off. = Immediate Offset
cutoff ben = benefit accrued at cutoff date
ret ben = benefit accrued at retirement
ER = early retirement
AP = Alternate Payee
P = Participant
REA = Retirement Equity Act


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16.13 Calculation of Present Value of a Defined Benefit Pension

The fundamental concept in calculating a present value of future payments is the concept of discounting. In order to understand discounting, first consider the concept of compounding. Assume one invests $1,000 in a five-year CD, with a compound interest rate of 6 percent. The future value of the CD at maturity is given by:

(1) Future Value = $1,000 x (1.06)5 = $1,338

Therefore, the present value today of $1,338 in five years, discounting at 6 percent interest is given by:

(2) Present Value (PV) = $1,338 x 1/(1.06)5 = $1,000

The fact that the present value is $1,000 is not surprising. Thus, discounting without mortality is simply the inverse process of compounding. Instead of a lump sum, consider discounting a five-year annuity of compounding.

Instead of a lump sum, consider discounting a five-year annuity of $1 per year. This is called a five-year certain only annuity. Instead of discounting the single lump sum of $1,338 for five years, each $1 payment is discounted separately, then added up. In essence, there are a series of $1 lump sums. The present value of the first dollar payment is $1, assuming payment at the beginning of the year. This is because the first dollar is received now, so there is no discounting. The second dollar payment has one year of discounting at 6 percent interest. The third dollar payment has two years of discounting, and the last payment has four years of discounting. After discounting each installment, the present values are then added up. Mathematically, this is expressed as follows:

(3) PV = 1 + 1/1.06 + 1/(1.06)2 + 1/(1.06)3 + 1/(1.06)4
          = 1 + .94 + .89 + .84 + .79 = $4.46

This is a commonsense result. The present value of a lump sum payment of $5 four years from now, discounted at 6 percent interest is $3,9605. However, in the annuity, only the last payment is discounted four years. The average amount of discounting is two years, with two payments discounted less than two years, and two payments discounted more than two years. As an approximation, imagine that the five payments of $1 is a single $5 payment two years from now. Then the present value would be:

(4) PV = $5 x 1/(1.06)2 = $4.45

This result of $4.45 is a reasonable approximation to the correct result of $4.46. Please note that this approximation is not used in real actuarial calculations but merely used here as an illustration to provide some commonsense, intuitive feel for the calculations.

Instead of the five-year annuity used above, consider a more realistic $1,000 per month annuity, payable over the annuitant's lifetime, for a male age 65, using the technique of life expectancy. Since the life expectancy of a male age 65 is 17 years, the annuity now is for 17 years, not five. This is called a 17 year certain only annuity. In actuality, the annuity is payable over the annuitant's lifetime. This is called a single life annuity. The annuity does not go 17 years and then stop. An accurate calculation, performed by an actuary, will account for the probability of mortality in each and every year from now (age 65) until age 110 (where the mortality table ends). However, life expectancy is a starting point. First, consider the $1 per year annuity, now for 17 years. The present value of this annuity is given by:

(5) PV = 1 + 1/(1.06) + 1/(1.06)2 + ... + 1/(1.06)16 = 10.8147

However, the payments are not $1 per year, but $12,000 per year. Thus, the present value (using life expectancy) is as follows:

(6) PV = $1,000 x 12 x 10.8147 = $129,776

As mentioned previously, life expectancy is not a method used by actuaries. The reason is that the most likely outcome for a male age 65 is to live 17 years. It means that with 100 percent probability, the individual will live 17 years, then die. But the individual may die tomorrow, or live to be 110. Since the probability of anyone living past the age of 110 is minute, the table ends at age 110. The only way to account for each possible outcome is to use probability of mortality, for each and every year from 65 until 110. Thus, the $1 per year annuity now goes on for 45 years, until age 110. However, each year's payment is discounted with interest and mortality. Thus, using life expectancy, the lust year's payment is not discounted. While there is no discounting for interest, there is discounting for mortality, since the individual may die within the first year. Therefore, the $1 is multiplied by the probability of surviving the first year. The second year's payment of $1 is multiplied by the probability of a male age 65 living one more year, and is discounted with one year's interest (at 6 percent). The third year's payment is multiplied by the probability of living two additional years, and discounted with two years' interest. This goes on until age 110. The $1 payment in that year is multiplied by the probability of the individual living to collect it, and discounted back to the present with 45 years' interest. The present values are then added up, as in the life expectancy example. The procedure just described is given mathematically as follows:

(7) PV = 1 * P65 + (1P65)/(1.06) + (2P65)/(1.06)2 + ... + (45P65)/(1.06)45
          = 9.9165

This is the present value of a $1 per year annuity. But the annuity is actually $12,000 per year, and so the present value is given as:

(8) PV = $1,000 x 12 x 9.9165 = $118,998

Note that there is a significant difference between the life expectancy result and the correct result using probability of mortality. Life expectancy is a simplistic method used by non-actuaries, such as accountants, in valuing pensions, and is not accurate.

Now consider the most common case, in which the individual has not yet retired. Assume that the annuity of $1,000 per month is payable at age 65, the normal retirement age of the pension plan, but the individual is age 50. First, consider the life expectancy case. At age 50, the life expectancy is 29 years, as opposed to 17 years at age 65. Thus, in this computation, the pension only goes for 14 years, not 17-that is, from age 65 to age 79. Thus, the present value at age 65 is $115,133, not $129,776, using life expectancy, since the annuity is now for only 14 years, not 17. The present value at age 65 for an individual age 50, versus the present value at age 65 for an individual age 65, is a confusing concept necessitated by the use of life expectancy, which is a mathematically unsophisticated technique. This cumbersome step is not needed using probability of mortality. The next step is to discount this lump sum of $115,133 at age 65 back 15 years, at 6 percent interest. Note that equation (9) has the same form as the calculation in equation (1):

(9) PV = $115,133 x 1/(1.06)15 = $48,041

The $115,133 is not actually a lump sum, but it is mathematically equivalent to a lump sum. Of course, as noted previously, this result is not accurate anyway, but it is the correct result, given the use of life expectancy.

The last step is to calculate the present value for a male age 50, payable at age 65, using probability of mortality. Remember that the present value at age 65 is $118,898. As in the life expectancy case, this is discounted with 15 years interest, at 6 percent. However, in addition, it is necessary to multiply by the probability of the individual actually living from age 50 until age 65. Thus, the present value is given as follows:

(10) PV = $118,898 x 1/(1.06)15 x 15P50

Following equation (8), the value at age 65 is given by:

$118,898 = $1,000 x 12 x 9.9165

Substituting this expression for the $118,898 gives the following expression for present value:

(11) PV = {$1,000 x 12 x 9.9165} x (15P50)/(1.06)15

Collecting terms and "plugging in" the probability of living from age 50 to age 65, the present value at age 50 is given by:

(12) PV = $1,000 x 12 x {9.9165 x .8896/(1.06)15}
            = $1,000 x 12 x 3.6810
            = $44,172

Note that at age 65, the use of life expectancy overestimated the value of the pension. At age 50, the use of life expectancy underestimated the value of the pension. Again, this is one more flaw with the use of life expectancy.

The last term, 3.6810, is the present value for a male age 50, for a $1 per year annuity, payable at age 65. This is called the annuity factor: Now look at Exhibit 16-5, showing this result as a pension valuation report. Within the following chapters on federal, military, and Fortune 500 company pensions there will be several such sample reports.

EXHIBIT 16-5 Sample Pension Valuation Report


DATE: March 5, 1998
PREPARED FOR: Robert D. Feder, Attorney At Law
NAME OF EMPLOYEE: Paul Aspen
EMPLOYER: Doe Ind., Inc.
PLAN: Pension Plan (Defined Benefit)
 
Birth Date:
Entry Date:
Marriage Date:
Cut-off Date:
Valuation Date:
03/05/48
01/01/68
01/01/68
03/05/98
03/05/98
Retirement Age: 65
Retirement Date: 04/01/13
Status: Active
Sex: Male
Age: 50
 
1) Accrued monthly pension at cut-off date $1,000
2) Annuity factor 3.681
3) Present value (12 x item 1 x item 2) 44,172
4) Length of Plan service while married 30.16667
5) Length of Plan service to cut-off date 30.16667
6) Coverture fraction (item 4 divided by item 5) 1.00000
7) Marital present value (item 3 x item 6) 44,172
8) Marital employee contributions/account 0
9) Marital present value as of valuation date
    (greater of item 7 or item 8)
$44,172
 
Marital portion contingent on jurisdictional cut-off date.
Pension form: Life Annuity
Calculations in accordance with generally accepted actuarial standards
Interest rate: 6.00%          Mortality: GAM-83


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Reprinted with permission. © 2007, Aspen Publishers, Inc., from Valuing Specific Assets in Divorce, edited by Robert D. Feder.

PAC provides pension valuations, QDROs and actuarial reports for divorce attorneys and marriage dissolution mediators nationwide. Our Philadelphia offices are located in the suburb of Elkins Park, Pennsylvania, from where we serve the needs of legal professionals nationally, including east coast states such as New York, New Jersey, Virginia, North Carolina, Florida, Washington, D.C., and Maryland. Our Florida office located in Coral Gables, FL serves Florida family attorneys.
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