Does a Defined Contribution Plan Need to be Valued in a Divorce?
By: Mark K. Altschuler
Pension plans are usually either defined benefit or defined contribution plans. Two common examples of defined contribution plans are 401(K) and thrift savings plans. It is well known that defined benefit plans need to be present valued. Since defined contribution plans have an account balance for an individual, many family attorneys and mediators believe that a defined contribution plan does not need valuation. This is not so. In fact, a defined contribution plan not only needs valuation, but failure to do so can greatly underestimate or overestimate the pension value. This can have a serious impact on the client's equitable distribution. Although the valuation of a defined contribution pension is more straightforward than a defined benefit valuation, the defined contribution computation may be highly complex.
If the cutoff date is close to the valuation date and the pension is entirely marital, the family attorney or mediator need only use the current account balance, and does not need to get the defined contribution pension valued.
Suppose the cutoff date is several years before valuation and the date of entry is after the date of marriage. Then, the cutoff date account balance is entirely marital. However, using the cutoff date account balance will greatly underestimate the marital present value of the pension, while using the current account balance will greatly overestimate the marital portion. The marital account balance must be brought forward with earnings until the date of valuation. If there have been contributions after the cutoff date, the earnings on the marital portion must be segregated from the earnings on contributions after the cutoff date.
It turns out that performing this calculation accurately involves a considerable degree of computation. Essentially, the interest rate for every statement must be estimated. From this estimate, the marital and non- marital earnings can be directly calculated. The non-marital earnings plus non-marital contributions are then added to form the non-marital portion, while the cutoff date balance plus earnings on that amount form the marital balance. The non-marital plus marital portions are added and compared to the total account as of a known statement date close to the valuation date. Because the interest rate was estimated, the two portions must then be balanced so that their sum equals the account balance as of the statement closing date, forming an exact solution.
A simplified example will illustrate the process. In this illustration, assume that the cutoff date is 12/31/95 and the valuation date is 12/31/98. Assume that the date of marriage is before hire, so that the cutoff date balance is entirely marital. The annual interest rate is estimated based upon the annual gain.
*1.1015 is equivalent to an interest rate of 10.15%. This format is used for compounding interest.
The aggregate compound interest rate over the three year period is 1.3358, calculated by multiplying the three interest rates. The marital portion is 1.3358 x $100,000 = $133,580. This is the investment gain on the cutoff date balance, plus the initial balance. The non-marital portion is the sum of 3 contributions, plus earnings on those contributions. The total is $10,433. The combined marital balance plus non-marital balance is $144,013. But we know that the actual total as of 12/31/98 is $144,023. Multiplying each portion by (144,023/144,013) brings the total to $144,023, balancing the result. Thus, the marital portion as of 12/31/98 = (144,023/144,013) x $133,580 = $133,589. Practically speaking, the balancing step is not needed in this case, but is shown for illustration.
An approximate technique is adding up all the gains after the cutoff date, and calculating the marital portion using a ratio. However, this method can lead to large errors, and cannot be used at all if there are missing statements.
If the hire date is before the marriage, the marital portion as of the cutoff date must be calculated. In Pennsylvania, this is done by subtracting out the balance as of the date of marriage. If the date of marriage balance is unknown, coverture is applied in Pennsylvania. In Virginia and Florida, only the contributions made during the marriage, plus earnings on those contributions, are marital property. Most states do not have case law on defined contribution plans, which follows the general pattern of neglecting the valuation of these plans. But defined contribution plans are a significant and growing portion of the pension picture, and accurately valuing a defined contribution plan is as important as valuing a defined benefit plan.
For an accurate calculation of defined contribution pensions, contact Pension Analysis Consultants. The actuaries at PAC are also available to assist counsel in all other pension-related matters of a domestic relations case, including valuation of defined benefit pensions, early retirement incentives, joint and survivor annuities and QDRO's. In addition, PAC drafts domestic relation orders regarding stock options.