A number of common mistakes can happen when valuing defined benefit and defined contribution plans – including partial offsets and tax consequences.
What’s wrong with using a present value of a defined benefit plan in a marital settlement agreement?
In a state that uses coverture – which is roughly half the country – the marital portion is the benefit at retirement multiplied by the coverture fraction. The coverture fraction is determined at retirement, so it’s going to be a much larger benefit than the current benefit. If the alternate payee is offered a present value, he or she might get a certain sum per month until that number is reached; even if he or she gets an accrued benefit that has the present value stated, that is going to be less than the coverture formula. A perfect example of that was the Able case in New Jersey. They valued the pension at $100,000, and there wasn’t enough money for a complete immediate offset. They should have done a partial offset, but instead, they did a 50% QDRO. The mistake was compounded because they specified that she was to get $50,000 dollars – but New Jersey follows the coverture methodology, so by specifying a dollar amount, the husband argued that she wasn’t entitled to 50% of the coverture portion. So there was a dual mistake made in getting the pension present valued: not using that present value because there wasn’t enough for a complete offset, and then stating the present value in a property settlement agreement. In general, putting a present value of a pension in a property settlement agreement is a big mistake. It will shortchange the alternate payee.
Why should a defined contribution plan be valued?
A defined benefit pension is a monthly benefit in the future. We’re valuing the defined benefit pension today, but how are we going to value the 401(k) if their cut-off date is years ago? We’ve seen cases where the cut-off date has been 20 years in the past. We can’t use a balance as of three or four years ago because that doesn’t include gains and losses since that date. It has to be brought forward with gains and losses since that date – then it can be compared to the house and the other assets.
What about tax consequences?
If you look at pension versus cash, the pension is a pre-tax asset and cash is a post-tax asset. Some jurisdictions – New York, for example – are very stringent about taking tax into effect. You have to establish exactly what the participant’s tax rate is before you can discount a pension for taxes. Other states, like Pennsylvania, are more lenient and will leave it up to the discretion of the court to discount the pension for taxes. Since the pension pays in the future, you would need to estimate a potential tax rate; we recommend the parties settle on some reasonable tax factor between 12% and 20%. Our partial offset methodology will enable you to gross-down that pension to compare it to cash.