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