Types of retirement accountsSavings or accrued benefits for retirement fall into two broad categories:
- Defined contribution.
- Defined benefit.
Valuing defined contribution plans in a divorceThe 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 Rather, the individual pays taxes on the funds when the amounts are withdrawn in the future, usually when the individual has retired.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 However, if the funds are withdrawn prior to retirement, the income taxes that were put off (deferred) until retirement must be paid immediately.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 divorceThe 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.
Reference to an expertAn 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.