Why Does a 401(k) Need to be Valued in a Divorce?
You probably know that the way to value a Defined Benefit plan as a marital asset in divorce is to obtain a marital present value calculation, preferably done by a qualified actuary. Defined Contribution plans, on the other hand, are not as easily understood by the divorce practitioner as plans that need valuation. Because a DC plan has an account balance for an individual as of some particular date, many attorneys and mediators believe that a Defined Contribution plan does not need valuation. This is a misconception. In fact, a Defined Contribution plan not only needs valuation, but failure to do so can underestimate or overestimate the pension value. If the current balance as of trial date is used, contributions after the cut-off date and gains on those contributions will be included, thus overestimating the value of the DC plan. If the balance as of the cut-off date is used, this will not include gains from cut-off to trial date, and thus underestimate the marital value. The cut-off date is the point in time after which the non-employee spouse has no claim on the additional pension benefits earned by the employee. While this varies from jurisdiction to jurisdiction, it can typically be the date of separation, date of complaint, date of filing, or date of divorce.
The correct method is to take the balance as of the cut-off date, along with gains on this portion, excluding contributions after the cut-off date and gains on the post-marital contributions.
BASKET OF APPLES ANALOGY
Suppose the couple had a basket of 100 apples as of the cut-off date. Wife kept the basket, putting in 10 apples after the cut-off date. So as of trial date, the basket would then contain 110 apples. But the 10 post-marital apples are not marital property, and use of the basket value as of trial date is then incorrect, overestimating the value. However, in many states, including Pennsylvania, New Jersey, New York, Maryland, and Virginia, assets are valued as of trial date. The correct method, then, is to use the 100 apples as of the cut-off date, but the price of apples as of trial date. This is equivalent to using the DC account balance as of cut-off date, along with gains from cut-off to trial date.
STOCK MARKET LOSSES
What if there have been losses from the cut-off date to the valuation date? Approximately 90% of 401(k) participants have had losses over the last two years. The majority of these losses were between 10 and 25 percent over the two-year period. In this case, using the cut-off date balance will overestimate the marital value of the pension. Counsel representing the employee-spouse will want to calculate the losses on the cut-off date balance, from the cut-off date to the valuation date. Use of the current balance will include contributions made after the cut-off date, and counsel for the employee spouse will not want those extra contributions included in the marital portion.
METHOD OF CALCULATION: TIME WEIGHTED RATE OF RETURN
It turns out that calculating the gains or losses on the cut-off date balance accurately involves a considerable degree of computation, as well as sorting through all the statements from the cut-off date to the present date. The contributions and gains and/or losses from each statement are entered onto a spreadsheet. Using the time weighted rate of return formula, contributions after the cut-off date and gains/losses on those contributions are segregated from the gains/losses on the marital portion. This method of calculation is discussed in detail in Valuing Specific Assets in Divorce, Chapter 19B, by Mark K. Altschuler, published by Aspen Press, New York. Information on this book can be obtained on our website, www.pensionanalysis.com. or from Aspen Press, www.aspenpublishers.com.
PRE-MARITAL PORTION: HIRE DATE BEFORE MARRIAGE
If the plan entry date is before the marriage, the marital portion as of the cut-off date must be calculated. In Pennsylvania, this is done by subtracting out the balance as of the date of marriage from the cut-off date balance. Thus, the increase in the pre-marital portion is marital, since only the pre-marital portion is subtracted out. Once the marital portion as of the cut-off date is established, it is then brought forward to trial date with gains or losses, as discussed above. This method is called subtraction, and is also discussed in detail in Chapter 19B of Valuing Specific Assets in Divorce.
In Virginia (Moran, 29 Va. App. 408, 512 S.E.2d 834, 1999) and Florida (Blas, 704 So. 2d 741, 742; Fla. Dist. Ct. App. 1998), only the contributions made during the marriage, plus earnings on those contributions are marital property. The increase in the pre-marital portion is not marital property. This method is called tracing.
Most states do not have case law on Defined Contribution plans, following the general pattern of neglecting the valuation of these plans. However, most states do have case law on whether or not the increase in the pre-marital portion of an asset is marital property. For example, in New Jersey, while there is no case law on Defined Contribution plan per se, the Painter (65 N.J. 196, 320 A 2.d 484, 1974) case indicates that the increase on the pre-marital portion is not marital. In New York, the increase in the pre-marital portion is also found to be non-marital under Jolis(98 A.D.2d 692, 470 N.Y.S.2d 584, Supreme Court, Appellate Division). Thus, New Jersey and New York follow Virginia and Florida in that only the contributions made during the marriage and increase in those contributions are marital property. Valuations under these jurisdictions then use tracing.
IMPROPER VALUATION METHODS
The coverture fraction is used to determine the marital portion for Defined Benefit pensions, not Defined Contribution pensions. The Berrington case in Pennsylvania, Majauskas in New York, Hayden and Risoldi in New Jersey, and Primm in Virginia, all specify the use of coverture for Defined Benefit pensions, not Defined Contribution pensions.
Improper Use of Subtraction
The Subtraction Method, as discussed above, is only applicable in jurisdictions where the increase on the pre-marital portion is marital property, such as Pennsylvania. Subtraction is incorrect in New York, New Jersey, Virginia and Florida. After subtraction is applied to the cut-off date balance, gains and losses are then calculated from cut-off to valuation. Some valuators will provide a subtraction report that just subtracts the date of marriage balance from the cut-off date balance. This is something the attorney can do. Why pay for a report you can do yourself, and in any case, is incorrect? Without gains and losses after cut-off date, this is not a proper valuation for equitable distribution purposes. A competent valuator will only use subtraction in a jurisdiction where it applies.
Defined Contribution plans are a significant and growing portion of the pension picture. Accurately valuing a DC plan is as important as valuing a DB plan. For equitable distribution, the Defined Contribution plan should be valued, and valued correctly. This means establishing the marital portion as of the cut-off date (which may mean using subtraction or tracing if there is a pre-marital portion), and then calculating gains or losses on that portion from cut-off date to valuation date.
The actuaries at Pension Analysis Consultants (PAC) are available to assist counsel in Defined Contribution plan valuations as well as all other pension-related matters of a domestic relations case, including valuation of Defined Benefit pensions, early retirement incentives, and joint and survivor annuities. In addition, PAC drafts QDROs and all types of domestic relations orders for all kinds of plans, including stock options. We welcome your inquiry.