Types of retirement accounts
Savings or accrued benefits for retirement fall into two broad categories:
- Defined contribution.
- Defined benefit.
Defined contribution plans are essentially savings accounts, and defined benefit plans are guarantees made by employers to pay certain sums in the future.
Valuing defined contribution plans in a divorce
The valuation and distribution of defined contribution plans are the easier of the two general types of plans to value and distribute in a divorce. This is because defined contribution plans, or alternatively deferred compensation plans, are essentially savings accounts and, with a couple of caveats, are cash equivalents. The caveats entail accessibility and taxability.
In general, accounts such as individual retirement accounts (IRAs) and simplified employee pensions (SEPs) are generally accessible to the participant and can be converted to cash. If, however, employers are the source of the funds, they may place restrictions on withdrawals. Taxability can also be a major obstacle in accessing these types of funds.
The major benefit of a pretax retirement account such as an IRA or an SEP is that income taxes do not have to be paid on the earnings that generate the deposits to the accounts. Rather, the individual pays taxes on the funds when the amounts are withdrawn in the future, usually when the individual has retired. The benefit is that the tax rate of a retired person is usually much lower than that of an individual actively engaged in the workforce. However, if the funds are withdrawn prior to retirement, the income taxes that were put off (deferred) until retirement must be paid immediately. In addition, there are penalties assessed by the IRS on such withdrawals.
The tax consequences and penalties can be significant. For example, assume that a husband has a retirement account with pretax deposits of $50,000. If he withdraws $25,000 from his account to settle the marital estate, he will immediately incur an income tax liability on the $25,000. In addition, the husband’s withdrawal does not meet the criteria of any of the approved exceptions. Consequently, the husband’s transfer of funds will cost him significantly more than the $25,000 he had originally intended (assuming a 25% tax rate and 10% penalty, the husband’s outlay to the wife would cost him $33,750: 25,000 x .35 + 25,000).
This problem can be avoided if the wife does not immediately need the funds in the retirement account. That is, she can roll the funds over into a deferred compensation account of her own. However, caution must be exercised in how this is accomplished. If the husband at any time takes possession of the funds, then the funds are deemed to have been withdrawn, and the income tax and penalties will be applied. On the other hand, if the husband instructs his plan to transfer the funds to the plan of the wife, then no tax liability or penalty will come into play. The husband will pay income taxes on his share of the plan, and the wife will pay taxes on her share when the amounts are withdrawn.
Valuing defined benefit plans in a divorce
The presence of a defined benefit pension plan in a marital estate complicates the valuation and ultimately the division of the marital estate.
A defined benefit pension plan can be described by an example:
A company informs its employees, “If you work for us for twenty years and are making an average of $50,000 per year during your last three years of employment with us, we will pay you $1,375 per month for the rest of your life beginning when you are 65 years of age.”
The concept is that the employees have earned a retirement benefit that will be paid to them in the future. A spouse’s accrued benefit has value and, if it was earned during the marriage, it is part of the marital estate.
From an economist’s (and often legal) standpoint, the value that should be included in the marital estate is the present value of the future payments that are anticipated to be made.
For example, under the assumptions in our example, a 65-year-old man has a life expectancy of around 16 years. This means that he will receive a total of $264,000 in pension payments during those 16 years. However, the $264,000 is the sum total of all payments. The time value of money must be recognized for payments that are going to be received in the future. The most common example of this concept is savings bonds. Assume that a grandmother buys a savings bond with a face amount of $50.00 for her grandson. At the time of purchase, she pays $30.00, and her grandson can redeem the bond for its face amount of $50.00 in ten years. The $30.00 is referred to the discounted or present value of the bond.
Similarly, the time value of money must be recognized in the valuation of pension plans. If we assume a 5% interest rate in our example, the discounted value of the stream of payments will be $181,475 at age 65. However, if the pensioner is seeking a divorce at age 50, it is still 15 years until he will begin receiving his pension. When the time value of money is recognized for this 15-year period, the present value of the $181,475 is $85,500. The $85,500 is the amount that is includable in the marital estate. The computations of present value are accomplished by the use of present value tables or, more commonly, calculators and computer programs designed for the purpose.
In addition to the application of mathematical computations that are out of the ordinary mainstream of life, there are a number of other factors that complicate these valuations:
- The calculations can be complicated by the timing considerations that are inherent in divorce. For example, if part of the pension was earned prior to the marriage (or perhaps after the separation), the amount of the pension has to be adjusted to recognize the non-marital portion.
- There are various life expectancy tables, and actuaries often have alternative methods and means of determining life expectancy.
- Pension plan administrators often do not understand that increases in the value of a pension plan cease as of the date of divorce. This lack of understanding can lead to estimates of monthly pension payments that include assumptions about increases in pay and additional years worked.
- Pension plans may have provisions for cost of living adjustments. Whether or not to include an estimate of these adjustments in the present value of a pension plan is problematic. Assumptions necessary to compute the present value of a plan such as the date of expected retirement can significantly change the present value of a plan.
The accumulated benefit in a pension plan can be a huge portion of the marital estate, even to the point of exceeding the equity the couple has earned in their residence. Mistakes in this area can have significant consequences. Consequently, assessing the value of a defined benefit pension plan should be delegated to a specialist.
Reference to an expert
An expert should be familiar with local legal requirements for pension valuations. If the expert is serving in a neutral capacity (working for both parties), he or she should be instructed to provide the effect of alternative assumptions (e.g., a retirement age of 65 versus a retirement age of 60).
Ensuring that the valuator has all of the information necessary to complete a valuation will help to ensure relevant assumptions and timely completion. The pensioner can provide information such as the date of marriage and separation, and can sign a release to allow the pension plan administrator to provide other information to the valuator. In fact, some valuators, if they are going to testify in court as to the present value of a pension plan, require access to the pension plan administrator to ensure the accuracy of the information that will be used in his or her expert opinion. In either case, the information obtained will usually consist of:
- Valuation date.
- Pensioner’s date of birth.
- Pensioner’s race.
- Pensioner’s sex.
- Monthly pension benefit.
- Date of hire.
- Date of termination.
- Date of marriage.
- Date of separation.
- Normal (or expected) retirement age.
- Discount rate.
- Releases for valuator to contact pension plan administrator.
The date that the pension plan is valued can affect the total amount that is ultimately computed. The valuation date can be set by agreement, court order, or by statute. For example, the parties can agree that the valuation date can be the date of separation or some other arbitrary date after the separation. Courts can establish the date of valuation of the marital estate, and the date of the pension valuation should comply with this date. Some jurisdictions may require a specific date for the valuation of the marital estate. In some states, the date of the divorce hearing is the valuation date. This type of requirement will create a situation in which the valuator performs the valuation and then updates it as the court date is set.
The pensioner’s date of birth is used to determine the age of the pensioner as of the computation date. This is necessary to determine the expected longevity of the subject. Since most defined benefit pension plans are for the life of the pensioner, the expected date of death serves as the end point to the string of anticipated pension payments.
Determining the pensioner’s exact racial lineage is not necessary. The reason valuators need the information is that there are different longevity tables that are based upon race. That is, some races tend to live longer than others. Similarly, females tend to live longer than males. Longevity tables take these factors into consideration.
The dates of hire, termination, marriage, and separation are used to mathematically segregate the marital portion of the marital estate from the non-marital portion.
The discount rate is the percentage that is used to recognize the time value of money. The higher the rate, the lower the value of the pension. This rate is normally determined by reference to current or historical federal investment rates of interest such as treasury securities. Excessive or diminutive interest rates will cause conflict and delay the resolution process.
The date of retirement will have a significant effect on the present value of a pension plan. An early retirement date can dramatically increase the value of a plan because the beneficiary will receive payments for a longer period of time. A divorce can also interfere in this assumption.
For example, a man and wife may have assumed for years that the husband will be able to retire when he is 55. The divorce, however, has financially impaired the husband, and there is no way that he will be able to retire at 55. The wife will claim a retirement age of 55, and the husband will argue his financial reality: age 60 (or later). Some employers specify an age of retirement such as age 62. Other employers, because of the physical demands of their positions (e.g., police and fire departments), specify a much earlier date of retirement such as age 50. Employers may also track the age at which employees typically retire. Averages of these statistics can be used to determine a fair assumption of the date of retirement.
Penalties for early retirement
Penalties for early retirement may be assumed by a pension plan administrator. These penalties are not usually considered on an economic basis unless the early retirement is actually going to occur. In addition, local jurisdictions may have established rules concerning the consideration of these penalties. In any case, the attorneys and neutrals can pursue establishing the handling before valuation procedures are performed.
Equivalency to purchased annuities
It is possible to purchase financial products that will pay a fixed monthly sum for a fixed period of time (e.g., the rest of a person’s expected life) at a certain percentage rate. These products are called annuities.
Attorneys and some valuators have claimed that these products are equivalent to the present value of the future benefits of defined benefit pension plans. In other words, if a company selling annuities is given the future monthly benefit, when it is supposed to start and when it is supposed to end, it will be able to quote a price for the annuity.
The problem with such an approach to valuation is that the annuity company, as part of the price quote, is including its cost to administer the annuity, profit for the company, and perhaps compensating itself for the risk associated with fixing an interest rate. These costs will not be incurred by a pensioner in receiving his or her benefits in the normal course of retiring. Consequently, the annuity price quote may be materially less than the present value determined by the use of current or average rates of interest.
Contributions versus present value
It is not unusual for employers, especially governmental units, to require contributions to a pension plan from employees as a condition of employment. The employer also makes contributions to the plan. These contributions accumulate, along with any earnings, in an account established for the employee. In some cases, as soon as vesting has been completed, the employee is free to withdraw the funds upon termination of employment.
Extreme caution should be exercised in these situations because the cash-out value of the plan may be very small in relation to the present value of the future benefits. This is especially true in the case of long-term employees. Most jurisdictions hold that the present value of the future benefits is the value of the plans and not the immediate cash-out.