Pension plans, particularly defined benefit plans, present unique valuation and division considerations during divorce. Understanding these complexities is crucial for ensuring a fair and equitable outcome for both parties.
Click here to Download our During Divorce Guide
What Is a Defined Benefit Pension Plan?
A defined benefit pension plan is a retirement plan where an employer or entity promises a specific monthly benefit to employees at retirement. Often, these benefits are calculated using a formula based on factors such as current salary and years of service. Unlike defined contribution plans like a 401(k), the employee doesn't directly manage the investments. The employer is responsible for managing pension investments and generally pools the assets of all the pension enrollees together. Generally, this adds additional complexity to both properly value and separate pension assets in a divorce.
Determine the Type of Defined Benefit Pension Plan and Unique Rules
Valuing or dividing a pension requires identifying the type of plan and its specific rules.
Private vs. Public:
- Private Pensions are governed by the Employee Retirement Income Security Act (ERISA) and are often divided using a Qualified Domestic Relations Order (QDRO).
|
An Important Note: A “Domestic Relations Order” is an order drafted by a legal professional and approved by the court that is used to divide any workplace retirement plan governed under the Employee Retirement Income Security Act (ERISA). This includes most workplace plans, such as pensions and 401(k)s. Once the plan administrator reviews the Domestic Relations Order and determines it meets the necessary requirements of the plan and QDRO rules, they qualify it and make it a “Qualified Domestic Relations Order”. The QDRO process can be complex. It is highly recommended that you work with a legal professional with experience drafting Domestic Relations Orders to ensure they are drafted compliantly. |
- Public Pensions, such as those for state or government employees, may have different division rules. For instance:
- Missouri's State Employees' Retirement System (MOSERS) requires a "Division of Benefits Order" (DBO) to split rather than a QDRO. A division of benefits order is similar to QDROs in many ways, but apply to public plans whereas QDROs apply to private plans.
- Kansas Public Employees Retirement System (KPERS) generally accepts QDROs for dividing benefits.
In any case, the correct orders to separate pension benefits (assuming that is the agreed upon outcome) are typically prepared by an attorney as part of the divorce process.
Not All Pension Plans May Be Divided
Some public pensions, like Missouri's Public School Retirement System (PSRS), may be considered non-divisible. Since PSRS is a replacement for Social Security, and Social Security is not divisible, PSRS is also not divisible under Missouri law. This does not mean its value is necessarily ignored, however. In some instances, even assets deemed non-marital may be a factor when negotiating elements of a divorce. As such, values of a pension such as PSRS should still be calculated.
Valuing and Determining How or If to Divide a Pension
Valuing and dividing a pension require careful consideration and often professional expertise.
Determining the Current Value:
Sometimes the pension plan administrator can provide the current value of a pension plan. However, often, only an estimated future benefit available years into the future is available. In a divorce, it's crucial to distinguish between a present-day value and a future retirement benefit value.
Future dollars are worth less than present-day dollars. Simply adding up future payments doesn't accurately reflect the pension's current worth. Proper valuation requires discounting future benefits to their present value, as described below.
State Rules and Valuation Methods:
State laws and local guidelines dictate acceptable valuation methods for pensions. For example, Johnson County Family Law Guidelines in Kansas recognize two methods to value defined benefit pension plans:
Method 1. Present Cash Value Method:
This method is one of the most common methods of valuing a pension in a divorce. However, it requires a complex calculation, and consulting a financial professional specializing in pension valuations is highly recommended. Here are the steps:
-
- Determine the vested benefit and eligibility date.
- Calculate the after-tax monthly benefit.
- Discount the after-tax benefits expected in one’s lifetime to their retirement value. The “discount rate” is a comparable rate of return one could earn with a typically conservative investment, such as a long-term Treasury bond.
- Further discount the retirement value to its present-day value (if not currently retired and eligible today).
- Determine the marital portion of the benefit, accounting for pre-marital contributions and service history. Separate the calculated present-day value of the pension into two values based upon the estimated portion of the pension earned for years of service that occurred prior to the date of the marriage.
The steps above may best be explained with a simple example:
|
A Divorce Example - John John, age 52, is eligible to receive a pension benefit of $2,000 per month at age 60. The appropriate “discount rate” being used to value the pension is 3%, and a review of John’s life expectancy determines he is expected to live until age 85. All the pension was earned during the marriage, and John’s appropriate income tax rate is 25%. Step 1. The after-tax monthly benefit John expects to receive is $1,500 ($2,000 * 0.75). Step 2. The value of this after-tax benefit amount at retirement is $317,105. In other words, if John had $317,105 available at his retirement age of 60 and earned a 3% rate of return, he should be able to recreate the exact income stream of $1,500 per month from retirement until he is 85. This value is calculated by utilizing either a financial calculator or spreadsheet tool. Step 3. The value of the pension today (and value assumed as part of the asset division) is $250,326. This is also solved by using a financial calculator or spreadsheet. $250,326 invested today at 3% would result in the accumulation of $317,105 at John’s retirement in 8 years. $250,326 is the value of the pension under the “present cash value method”—equivalent to the same amount of cash today. Although John is expected to receive $600,000 in payments over his lifetime ($2,000 times 300 payments), those occur far into the future and ignore taxes. As such, using a value for the pension of $600,000 would not be equitable for John. |
Given a choice between this pension and $600,000 in other assets, most would select the $600,000 in assets that are available today. Dollars in the future are worth less than equal dollars today due to factors like inflation. This is why the calculation of present value is necessary.
Under this “Present Cash Value Method”, the estimated present-day value of the pension determined in the steps above is listed on the marital statement of assets. While the employee-participant in the pension may be allowed to retain the pension in full, the value of the pension retained may result in other comparable alternative assets of equal value being granted to the spouse who is not a participant in the plan.
Method 2. Reserve Jurisdiction Method:
Under this method, the employee-spouse must begin paying a certain portion of retirement benefits to their former spouse as soon as they receive them in the future. For example, if the current vested pension is $2,000 per month, the non-participant spouse may be granted the right to receive $1,000 per month as soon as the participant spouse retires.
This method is not always available as not all pensions allow for their benefits to be divided. If they are allowed and divided in the divorce agreement, however, the attorneys often must prepare separate legal documents to provide to the plan administrator to entitle the non-participant spouse to be eligible to receive benefits as an “alternate payee”.
Conclusion
Divorce proceedings involving defined pension plans require careful planning and expert guidance. Understanding the type of pension, its specific rules, and appropriate valuation methods is essential for achieving a fair and equitable division of assets. Consulting with legal and financial professionals specializing in divorce and pension valuation makes navigating these complexities and protecting your financial future much easier.
Ready to get Started?
Schedule a call with one of our Certified Divorce Financial Analysts™ (CDFA®) professionals today!
Investment advice, financial planning, and retirement plan services are provided by Prosperity Planning, Inc., an SEC registered investment advisor. The information contained herein, including but not limited to research, market valuations, calculations, estimates and other material obtained from these sources are believed to be reliable. However, Prosperity Planning, Inc. does not warrant its accuracy or completeness. The information contained herein has been prepared solely for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or to participate in any trading strategy. If an offer of securities is made, it will be under a definitive investment management agreement prepared on behalf of Prosperity which contains material information not contained herein and which supersedes this information in its entirety. Any investment involves significant risk, including a complete loss of capital and conflicts of interest. The applicable definitive investment management agreement and Form ADV Part 2A will contain a more thorough discussion of risk and conflict, which should be carefully reviewed before making any investment decision.
