Divorce is a complex process, and the division of assets can be one of the most challenging aspects. Among these assets, pension plans, particularly defined benefit plans, often present unique valuation and division considerations. Understanding these complexities is crucial for ensuring a fair and equitable outcome for both parties.
A defined benefit pension plan is a type of 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 401(k)s), the employee doesn't directly manage the investment; the employer bears the investment risk.
Before attempting to value or divide a pension, it's essential to identify the type of plan and its specific rules.
Private vs. Public:
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.
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 dividing a pension require careful consideration and often professional expertise.
Determining the Current Value:
Sometimes, a current value is provided by the pension plan administrator. However, often, only an estimated future benefit available years into the future is available. 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. This concept is explained in greater detail 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 requires a complex calculation, and consulting a financial professional specializing in pension valuations is highly recommended. However, this is one of the most common methods of valuing a pension in a divorce. The steps are as follows:
The steps above may best be explained with a simple example:
John, age 52, is eligible to receive a pension benefit of $2,000 per month at his 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 available $317,105 at his retirement age of 60 and earned a rate of return of 3%, he should be able to recreate the exact income stream of $1,500 per month from retirement until he is 85. This value is solved for 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. Note 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 – any sane person would select the $600,000 in assets that are available today. This is why the calculation is complex – dollars in the future are worth less than equal dollars today.
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 granted the ability 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.
As noted above, 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 have to 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”.
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 is highly recommended to navigate these complexities and protect your financial future.
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.