The Basics of Pension and Divorce

1. What is a pension plan?
A pension is a plan "established and maintained by an employer primarily to provide systematically for the payment of definitely determinable benefits to his or her employees, or their beneficiaries, over a period of years (usually for life) after retirement."

2. What is the difference between a defined benefit plan and a defined contribution plan?
A defined benefit plan (DBP) promises to pay a monthly benefit to the participant at retirement for the duration of the member’s lifetime. The payment is based on a specific formula described in the plan summary, and it usually incorporates years of service with the company and salary at the time of retirement. The old-fashioned company pension given for years of faithful service is a defined benefit pension.

A defined contribution plan (DCP) is one in which the member makes voluntary contributions to an account in his or her name. The employer may or may not make matching contributions. The amount accumulated includes all the contributions as well as any gains or losses. The popular 401(k) is a defined contribution pension.

3. Why are pensions divisible in divorce?
Pensions are property in that they are 1) certain and 2) transferrable. Certainty means that the rights exist unconditionally in the present rather than rights that may possibly exist in the future. Transferability means that they can be given to another person on a permanent or temporary basis in return for consideration. Pensions are intangible property subject to distribution in a divorce.

4. Explain the two basic property models.
In a divorce, courts divide property using one of two regimes or models – one called the "all property" model, the other called "dual classification." The particular model used in a particular jurisdiction depends on case law and statutes and the practices of the state court.

Fourteen states -- Connecticut, Indiana, Kansas, Massachusetts, Michigan, Mississippi, Montana, New Hampshire, North and South Dakota, Oregon, Vermont, Washington, and Wyoming – use the "all property model." In this routine, the court can divide any interest that constitutes property owned by one or both parties on the date the state considers the marriage to have ended (i.e. divorce date, separation date, complaint date). In other words, it does not matter when the property was acquired, or whether it was before the marriage or during the marriage. Under this model, all property owned by the parties on the date their marriage ended constitutes marital property, and it can be divided when they divorce.

The other model is called the "dual classification model." This model is similar to the "all property model" in that in order to be divided in a divorce, the property must be owned by one or both parties on the date the marriage ended. However, the difference is that the property must have been acquired during the period of marriage. Therefore, under this model, only that portion of the parties’ pension benefits earned during the marriage is marital property subject to division in the divorce. Any portion of the pensions earned before the parties married is their separate property.

5. How is marital property determined?
Generally, any portion of a pension earned outside of the marriage is separate property and not divisible; any portion earned during the marriage is marital property and divisible.

Dual classification states treat the growth of the separate property portion of pension plans in different ways. Some states hold that any growth in the separate property during the marriage is marital property; other states say that any growth in the separate property during the marriage would be considered separate property. This is also true for defined benefit plans.

Under a defined contribution plan, any growth in the owner’s separate property, which is that portion of the pension that was earned prior to the marriage, could be considered separate property. Each dual classification state model looks at this issue differently.

A defined benefit plan does not grow in value unless the member continues working; a defined contribution plan continues to grow even if the member stops working.

6. Explain the two methods for dividing pensions.
There are two competing methods of division, each with its own rules. One is called the immediate offset method and the other is known as the deferred distribution method. The major difference between these two methods is the time at which division is accomplished.

7. How does the immediate offset method work?
Under the immediate offset method, a pension appraiser determines the present value of the retirement benefits. The nonemployee spouse is awarded his or her share of the benefits as an immediate lump-sum award of cash or other property (i.e., additional equity in the marital home, a time-share purchased during the marriage, etc.).

8. What are the three methods for valuing a defined contribution plan?
The three methods for valuing a defined contribution plan are 1) the segregation method, 2) the subtraction method and 3) the coverture method.

9. Describe each method.
In the segregation method, the account balance on the date of marriage, plus all interest and investment growth is subtracted from the account balance on the date the marriage ended. The difference is the value of the account subject to equitable distribution. This approach assumes that any growth in separate property during the marriage is considered separate property. If the immediate offset method is chosen for division of this asset, this method can be used to track the growth on the marital portion of the plan from the date the marriage ended to the date of distribution.

In the subtraction method, the account balance as of the date of marriage is subtracted from the account balance as of the date the marriage ended. The difference in the account balances is the value of the account subject to equitable distribution. This approach assumes that any growth in separate property during the marriage is considered marital property.

In the coverture method, the account balance as of the date marriage ended is multiplied by a coverture fraction to determine the value of the account for equitable distribution.

10. What are the two methods for valuing a defined benefit plan?
Pension Appraisers, Inc. offers two methods for valuing defined benefit plans: the GATT Method and the PBGC Method. You can have a pension valued online at PensionAppraisalDesk.com.

11.What is the difference between the two methods?
The difference between the two methods is in the interest rate assumption used to discount the income stream to present value. The GATT Method uses the 30-Year Treasury Bill Rate and the PBGC Method uses the interest rates set forth by the Pension Benefit Guaranty Corporation.

12. What is the relationship between interest rates and present value?
There is an inverse relationship between interest rates and present value. A higher interest rate will yield a lower present value and vice versa.

13.What are cost-of-living adjustments?
A cost-of-living adjustment is a small incremental increase in retirement benefits, granted to retirees by a plan in an attempt to keep such benefits in line with inflation. When incorporated into a present value analysis a cost-of-living adjustment increases the present value.

14. What is ERISA?
ERISA (Employee Retirement Income Security Act of 1974) is the federal statute established to protect the interests of employees who participate in employer-sponsored pension plans.

15. What is REA?
REA (Retirement Equity Act of 1984) is the federal statute that created a limited exception to the antialienation provisions of ERISA and provided for the creation of QDROs. This exception provides that benefits accrued by an employee may be paid to another person provided such person meets the definition of an alternate payee, and the order issuing such payment meets the criteria of a QDRO.

16. What is the PBGC?
The PBGC (Pension Benefit Guaranty Corporation) is the government agency that was established by ERISA to protect or guarantee a certain portion of a plan participant’s benefits in case of voluntary or involuntary plan termination.

17. What are a QDRO and a DRO?
A QDRO (qualified domestic relations order) or DRO (domestic relations order) is a written set of instructions that explains to the plan administrator that a portion of an employee’s benefit is subject to distribution due to a divorce. In order for it to be distributed it must be in the form of a court order and meet various other requirements.

18. What are the three reasons for drafting a QDRO?
A QDRO can be drafted for 1) equitable distribution of marital property, 2) child support, or 3) spousal support or alimony.

19. Who qualifies as an alternate payee under a QDRO?
The definition of an alternate payee is a spouse, former spouse, child or other dependent of the plan participant.

20. What is vesting?
Vesting is the conveying to an employee of unconditional entitlement to a share in a pension fund. Vesting requirements are normally set forth in the summary plan description.

21. What is a "valuation date"?
The valuation date is the date from which the interest rate (or discount rate) used in determining present value is drawn thereby establishing a value as of that date.

22. What is the "classification date" (or cut-off date or date marriage ended)?
The classification date is the date that marital property rights relative to the pension terminate. This date is usually dictated by case law or statute in a particular state.

23. What is meant by normal retirement age?
Normal retirement age is the age at which a pensionholder can retire and receive an unreduced benefit. Early retirement age is the age at which an employee may retire and begin receiving reduced benefits. Both the normal retirement age and the early retirement age are usually dictated by the terms of the plan.

24. What is a coverture fraction?
A coverture fraction is a tool used to determine that portion of the value of the benefits attributable to the marriage. The numerator of the fraction represents the total period of time the pensionholder participated in the plan during the marriage, and the denominator is the total period of time the pensionholder participated in the benefits program.

25. What is an accrued benefit?
An accrued benefit is the benefit earned under a defined benefit plan as of a specific date.

Authored By: Theodore K. Long, Jr., President, Pension Appraisers Online, Inc.

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