A separation or divorce often involves a significant change in the economic future of your client. Often the parties to a divorce are participants in pension plans that provide retirement benefits either in a lump-sum form upon retirement or a monthly benefit. Attorneys are often faced with the prospects of having the value of the pension offset against other assets of the marriage or having the plan divided by way of a Qualified Domestic Relations Order (QDRO). What is needed is a brief explanation of the valuation process with a focus on the practical interpretation of how certain factors assumed in a valuation model affect the final present value of the retirement plan.
Pension plans fall under the broad classification of either Defined Benefit or Defined Contribution plans. A Defined Benefit Plan is one that is expected to pay a monthly benefit at a certain retirement age based on, in most cases, the participant's length of service and/or salary. In contrast, a Defined Contribution Pension Plan defines a "contribution" to be made now with the future value of the benefits left uncertain. Many individuals are participants in each type of plan or one that is a combination of both. The basic theme of this writing is to provide the attorney with not only the basic tools for valuing a participant's interest in a pension, but also provide the attorney with an understanding of the process and ability to critique the work of others.
Plans which have "Pension Plan" in their titles, such as XYZ Co. Pension Plan, or "Retirement Plan", tend to be defined benefit plans paying a specific monthly benefit at a certain retirement age.
Plans that have "Savings Plan", "Retirement Savings Plan", Incentive, Profit Sharing, ESOP, will be defined contribution plans where the account balance at any particular time is the present value.
Defined Contribution Plans will not be the main focus here since the value is easily determined by the account value. The other type of pension plan, the Defined Benefit Plan, promises to pay a specified monthly benefit to the participant at a certain age for a specified period of time. It is this type of plan which will be the main focus of discussion. Defined benefit plans are generally 100% employer funded where the monthly benefit is primarily based upon the number of years of service and average annual income of the individual plan participant.
The calculation of the lump-sum present value itself is rather simple, however, with regard to a pension it is a two stage process. The first stage converting the stream of income into a present value at the pension participant's retirement age, and the second stage taking that lump-sum equivalent and bringing it back into present value terms. Present value formulas, which are easily found, can be used or ideally a financial calculator. The period, from the retirement age to the age at death, is commonly referred to as the payout period.
This period is referred to as the deferral period or accumulation phase. Certain discounts are applied throughout the process to eventually arrive at a present value to the participant of his/her pension plan.
One assumption is the answer to the question of what if the plan participant dies prior to receiving their pension, thus, allowing the non-participant spouse to acquire other marital assets of equal value long before the retirement date. Therefore, prior to discounting the lump-sum at retirement to present value, a mortality discount is made. That is, discounting for the probability of death of the participant prior to attaining their retirement date. This is done by utilizing mortality tables, such as the Vital Statistics of the United States or the Statistical Abstracts and simply dividing the number alive out of 100,000 or at the participant's retirement age by the number alive out of 100,000 for the participant's current age, as given in the tables. For instance, at a participant's age forty-five, and given a retirement age of sixty-five, the participant would have approximately an eighty percent chance of surviving to retirement or a twenty percent chance of dying prior to retirement. The lump-sum equivalent at retirement is multiplied by the eighty percent, or 0.8, to arrive at a value discounted for mortality. Again, the lump-sum at retirement is then discounted to present value.
There are five basic factors which affect the present value of a pension. The first is defining the payout period by determining the life expectancy. This, again, can be found in the Life Tables published in the Vital Statistics or the Statistical Abstracts of the United States which seem to more reliable than any other source and are updated yearly. Keep in mind that there are different life expectancies for any given age. Therefore, when valuing a pension at two different ages, say 55 and 65, the life expectancies will be different. The longer one lives, the higher the probability of living longer.
Once the payout period is defined, the estimated age at death minus the retirement age, the most critical of assumptions will be the appropriate discount rate to use in the calculation of the present value. This is the rate applied to the income stream to determine the lump-sum necessary to fund such an annuity from the participant's retirement age until their average life expectancy. This is also applied in the second stage of the valuation process where the lump-sum at retirement is discounted to present value. It is a rate which represents the minimum rate of return one could expect if the plan participant were to fund their own retirement benefit, comparable to the one they are to receive by the pension fund, considering the payout and deferral period. It would have to be rate that could span a large period of time and preferably guaranteed. Conversely, if the non-participant spouse, i.e. alternate payee, pursuant to a QDRO could receive a lump-sum equivalent, what is the minimum rate of return they could expect? Although the term interest rate and discount rate are used interchangeably, simply keep in mind that interest rates go forward in time, i.e. present value to future value, whereas discount rates come back in time, i.e. future value to present value.
An important mathematical relationship to know and understand is the lower the interest rate/discount rate used in the calculation the higher the present value will be. The higher the interest rate the lower the present value. Present values and discount, or if your prefer interest rates, are inversely related meaning as one increases the other decreases. As you will see this assumption will become very crucial in determining a present value since this assumption alone can alter the present value of pension upwards of thousands of dollars
On occasion, a company, benefits department, or some pension appraisers will provide a present value based on the rates published by the Pension benefit Guarantee Corporation (PBGC). The use of those rates, or factors, are not encouraged, nor endorsed, by the PBGC for marital dissolution since theses rates are used for entirely different purposes. The PBGC rates are conservative in nature in that they are only used for insurance purposes. A graduated interest rate scale, as sometimes used, has no significance in the valuation process and often has a lower weighted rate than a government bond rate that is guaranteed to span several years. Therefore a rate such as the long-term treasury bond yield is ideal and often preferred.
Another factor affecting the present value is the monthly benefit and it's corresponding retirement age. Most plans have an early and normal retirement age even though they may only give a monthly benefit for one age. Valuing a pension at two different ages will almost always result in two different values. In many cases, the earliest retirement age will yield the larger present value but not always. It greatly depends upon the reduction factors applied to the normal retirement benefit in obtaining the early retirement benefit. Cost-of-living-adjustments (COLA's) or post retirement increases applied to the monthly retirement benefit will increase the present value. In observing pension valuations offered by the opposing counsel, keep in mind, that nearly all government plans have COLA's whereas most private non-governmental plans do not.
While it is true that most valuations provide recent and credible sources for these assumptions, different sources can be used to produce different results. Just as important as knowing the source of these assumptions is knowing why and how these sources affect the participant's pension value.
Tim Voit is a Financial Analyst and author of "Retirement Benefits & QDROs in Divorce", a CCH publication. Tim Voit has been involved in researching pension plans for valuation or QDRO purposes, in addition to assisting law firms in dividing retirement benefits on private, military, and governmental plans. Tim Voit is also a court admitted expert on pension related issues, as well as having been retained as an expert in malpractice cases on behalf of the insured to analyze and "fix" poorly drafted QDRO's. A sample questionnaire/authorization directed to pension plans, asking many of the questions addressed here, can be obtain by contacting our office via email at email@example.com