A pension is a reward for long and faithful service. A good pension plan helps to attract and retain good employees. A well-designed pension plan offers attractive tax benefits to both the employer and the employees. The employer receives a deduction for corporate income tax purposes for the contributions made to the plan. The assets of the plan are tax-sheltered; there is no income tax on the investment income of the plan, earned or unearned, realized or unrealized. There is no capital gains tax on the plan funds and no income tax so long as the plan remains its tax favored status under its Internal Revenue Code section. The employees are not taxed on the monies put aside for them or on the benefits accruing for their behalf.
The first pension in the United States was granted to disabled veterans of the Revolutionary War. The first military pension law was passed in 1818. In 1836, widows of soldiers of the Revolutionary War were covered by pensions. With the Industrial Revolution, private pensions became more common. The first formal private pension began in 1875 under the American Express Company. In 1974, private pensions became regulated under ERISA (Employee Retirement Income Security Act), which established the tax favored status discussed above.
A spouse in a divorce proceeding may lay claim to an employee's pension as community property or as marital property in an equitable distribution state. A pension is marital property because it is a form of deferred wage of the employee. If there were no pension plan, in theory, the worker would have received more take-home pay. All pay would be current, none deferred, and the paycheck would go into the marital pot while married. When the marriage ends by divorce and marital property is to be divided, the deferred wage aspect of a pension becomes important for consideration as an asset subject to allocation between the husband and wife.
The division of the pension as an element of property takes two separate forms. One form is for the present worth to be determined as a dollar amount and added to the inventory of all of the assets of the couple. That is the present value, immediate offset method. The other form is for a deferred distribution. By use of a certain kind of court order a claim is made on the pension plan that will pay funds to the non-employee spouse. This is sometimes referred to as the method of "if-as-and-when", but that is misleading.
A court order may arrange for a payment to the non-employee spouse even before the employee spouse gets a pension.
The court order is a domestic relations order, which becomes a qualified domestic relations order, both of which will be discussed later in this chapter. It is under the general category of deferred distribution.
In the use of immediate offset the worth of the pension is considered at the time of the settlement of the divorce case and is offset by comparison to other assets. The common relationship being something like "she gets the house; he keeps his pension". The terms present value and present worth are used interchangeably. It is the word "present" that causes some problems. It can be used to mean the time of marital dissolution: date of marital separation, filing of the divorce complaint, hearing or trial, or granting of the final divorce decree. Most often, the reference to "present" means the real time now when the pension is being valued.
A good working definition of present value would be that it represents a sum of money today that will grow with investment results to provide a lifetime pension starting at a future date, if the person lives to the pension starting date. An example to illustrate the concept would be for a man, let's say, to walk into the office of a reliable, reputable life insurance company that sells annuity products. He would have his checkbook with him. He would ask the insurance company what it would cost today to buy an annuity contract. The name of the contract is a single premium deferred annuity. The contract provides a guaranteed income in a pre-specified dollar amount, payable for as long he lives, backed by all of the assets of the insurance company, and further backed up by a state insurance solvency fund.
But, if he dies before he reaches the age when the annuity is to start, he forfeits his payment. There is no refund before retirement. When the monthly payment starts under the contract, the insurance company sends him a check every month for as long as he lives. It stops as soon as he dies. If he dies after receiving only a few payments, it is a mortality gain for the insurance company and adds to its profits. If he lives a very long time, collecting monthly payments, it is a mortality loss for the insurance company.
An example of a mortality loss is the case of Jean Calment, who was the worlds oldest person before she died at age 122. When she was 90, she sold her apartment to a lawyer, who agreed to make monthly payments and take possession when she died. After all, she was 90 at the time, and the monthly payments were relatively small. However, the lawyer died at age 77 before ever taking possession, and his family continued to make payments to Ms. Calment until she died, 32 years after the deal was transacted.
The insurance company prices its annuity products, and changes its prices often, based on the determinations and recommendations of its actuaries. The insurance annuity actuary takes into account changing trends in mortality, the sex and age of the purchaser, and interest rates. Also there must be an allowance for overhead, expenses, commissions to the selling agent, and of course profit for the company. When the man is told what to pay that day to buy his contract: that is the present value.
When an evaluator computes the present value of a pension as property for a divorce settlement, there does not have to be considered overhead, expenses and the like. Purely by the use of mortality and interest the mathematical worth of a future series of payments is determined. The evaluator must select a mortality basis and an interest rate to reflect the proper value in an unbiased and fair representation of what a person's pension is worth.
If the divorce case is such that the pension will be handled by deferred distribution instead of immediate offset it is still important to know the present value. How else do the parties know what the value is that they are settling for? The future distribution of a portion of a pension by court order has a present value just as the person's pension itself has a value.
Two types of pension plans come into question for both present value and deferred distribution. A plan is either a defined benefit pension plan or a defined contribution plan.
There are some hybrid types that will be dealt with later in this chapter.
Note that welfare plans are outside the scope of this chapter, such as life insurance, medical, dental, long-term disability, and so-called cafeteria plans which give the employee a choice of emphasis among the various categories of benefits. But pension plans are never part of a cafeteria arrangement.
A defined benefit pension plan has in it a formula by which an employee's pension payout is determined at retirement, usually based on pay and service. There is one pooled fund of plan assets from which benefits are paid. The employer's contributions are not earmarked for individuals. An independent actuary advises the employer on the plan's assets and liabilities and recommends the amount of the contribution to be made in total each year. A participant accrues a pension benefit for each year of credited service in the plan, along with vesting rights to that benefit. At retirement the employee has a choice of forms of pension payment, all of which have equivalent actuarial value at that time. In an ERISA plan (subject to the Employee Retirement Income Security Act), a married participant is limited in pension choices at retirement. A form of pension known as a 50% joint and survivor must be paid unless the participant and spouse both sign a waiver, properly witnessed. The waiver would allow the employee to receive a lifetime pension, ending at death, leaving nothing to any survivor.
Why would anyone who is married want such a pension?
While a joint and survivor form is required unless waived, it is not free. For example, a man reaches age 65 under a pension plan formula that provides a monthly pension to him of $ 1,000 for the rest of his life. That is the plan's "normal form" - a lifetime pension. It is computed under the plan's formula based on his pay and service. In order to convert it to a 50% joint and survivor form of pension the dollar amount has to be reduced to maintain the plan in actuarial balance. It would cost the plan more to pay a pension over two lives instead of one. In order to keep the cost equal, the amount to be paid is reduced.
In this example, the man would get a monthly pension of $ 850 instead of $ 1,000. He gives up $ 150 a month to provide for a form of insurance for his wife. When he dies after retirement, she gets 50% of the reduced amount: .50 times $ 850 equals $ 425. She gets $ 425 a month for the rest of her life. But, if he retires and she dies before he does he continues to receive the reduced amount of $ 850 for as long as he lives. He cannot substitute a beneficiary.
This "option" is a mortality risk that husband and wife should consider carefully before deciding.
In a divorce situation using a form of deferred distribution to award a portion of the pension to a spouse, it is possible to include some form of death benefit if the details are worked out correctly. A former spouse may be named as the beneficiary under a joint and survivor option.
A defined contribution plan has a structure remarkably distinct from a defined benefit pension plan. The federal law of pensions, ERISA, has created some unintended confusion in its nomenclature. It distinguishes between two types of plans - pension and welfare. In ERISA the term pension plan encompasses both defined benefit and defined contribution types of plans. Whereas in pension terminology, a pension plan is a defined benefit pension plan and a defined contribution plan has its own particular name depending on its type and contribution basis. A defined contribution plan has an individual account for each participant. Many such plans have more than one account or sub-accounts for each participant. The employer contribution is allocated among participant accounts. Investment gains (and losses) are allocated to the individual accounts. Some defined contribution plans allow the participant to make investment choices for his or her account, although the choices are generally limited to certain categories or sub-funds. If there is a domestic relations order in a divorce affecting a defined contribution plan it would be important to note whether the spouse may have the ability to make investment selections for the segregated account portion awarded by the court order.
The valuation of a defined contribution plan as marital property does need the services of an actuary.
A knowledge of the workings of the type of plan is needed along with some financial or economic familiarity for the evaluator to report a reasonable and appropriate result.
The defined contribution plan will report the account status to each participant individually at least once a year, and after four times a year. The report usually will show the person's opening account balance followed by the contribution allocated to the account, the share of investment gains or losses, and the balance at the end of the year. Vesting is often more generous in defined contribution plans than it is in defined benefit pension plans.
A popular form of defined contribution plan is the thrift or savings plan constructed in accordance with Internal Revenue Code section 401(k). It has become common for these to be known simply as 401(k) plans. The most advantageous feature of this type of plan for the employee is that the employee authorizes a contribution from his pay on a basis before personal income tax is imposed. The employee contribution is not subject to personal income tax when it is made, but it is taxable when it is withdrawn or otherwise paid as a benefit distribution. These plans may or may not have contributions from the employer. These plans are subject to valuation for immediate offset or for an award of all or part of the account by court order in deferred distribution.
A type of plan that may be either defined benefit or defined contribution is a Keogh plan, although most are of the defined contribution type. Keogh plans are named after the late former Congressman Eugene Keogh. They are also known as HR-10 plans, named because of the tenth bill introduced in the House of Representatives in 1962. These are plans sponsored and maintained by a sole proprietor or a partner. They are not corporate plans. No new plans of this type are established anymore, but there are many dormant plans that maintain tax-sheltered funds for the eventual retirement of the business owner or professional. No new contributions are made to these plans. Whenever the divorce concerns a person who in the past was a partner in a partnership or a sole proprietor of a business or profession, inquiry should be made as to whether there is an old Keogh plan. If so, the plan is subject to routine valuation for immediate offset and also subject to a court order for deferred distribution. A retirement plan asset that may exist and should be investigated is an Individual Retirement Arrangement (IRA).
This may be an individual retirement account with a bank, stockbroker, mutual fund or insurance company. A person may have several such accounts. Every IRA is of the defined contribution type. There is no such thing as a defined benefit IRA. An IRA is subject to valuation like any defined contribution plan for immediate offset, but deferred distribution is different from other types of plans.
A court order is not always needed to award a spouse an interest in an IRA. The Internal Revenue Code allows a tax free transfer from the IRA of one spouse to the IRA of another spouse incident to divorce. The particular institution or entity holding the IRA funds may insist on a court order to satisfy its own administrative requirements. An employer may establish IRA's for its employees for administrative convenience and as a goodwill gesture. Such an arrangement is known as a Simplified Pension Plan or SEP.
It is in every other respect the same as any IRA and may be valued or awarded in a divorce settlement.
Distributions from an IRA are taxable as personal ordinary income. If paid as a lump sum to an individual under age 59 1/2 there is an additional excise tax penalty of ten percent. Neither tax applies in an IRA transfer to another IRA in a divorce matter. However, one should be aware in contemplating a transfer that if the original IRA account must sell off securities or redeem a certificate of deposit before maturity a loss or penalty may occur that has nothing to do with taxation. In discovery in a divorce case, the list of questions should include one as to whether the spouse is a participant in any pension or retirement program that is informal, supplemental, unfounded or otherwise outside the normal range of ERISA plans. An employer may offer an incentive retirement bonus program to selected key executives. Such a plan is sometimes known as a "top hat" plan.
Formally it may be written as the executive supplemental deferred compensation plan. It may be a contract covering just one person, or it may be a group benefit. Valuation for divorce purposes is usually more difficult than it would be for and ERISA plan. A top-hat plan may have no vesting, or a complex vesting schedule. It may pay only a lump sum, or it may pay a combination of a lump sum plus a pension, or only a pension. It will probably not accept a court order to distribute a portion to a former spouse. Pension plans come in many shapes and sizes, under various names and with many different combinations of benefits, contributions and values. The next section deals with some special situations of interest.