Timothy C. Voit
Virtually any attorney who is familiar with this plan realizes the complexities of trying to determine a lump-sum present value when offsetting marital assets in a divorce. With approximately one-half million members in the Wisconsin Retirement System, and nearly 38 billion dollars in invested assets, attorneys practicing family law, or those attorneys dabbling in divorce, will encounter the valuation of this plan as a marital asset almost certainly during their career. Viewed as a marital asset, the importance of valuing this type of plan properly cannot be over emphasized. The lump-sum present value often exceeds the value of all other assets of the marriage and a slight alteration of an assumption can shift the lump-sum present value tens of thousands of dollars. Following is a concise, but practical, approach to valuing this type of plan for divorce.
First and foremost, the WRS Plan is two retirement plans in one. The Plan consists of an Employee Account and an Employer Account. The Employee Account consists of 100% employee participant contributions and is available in one lump-sum to the employee participant upon termination of employment either voluntary or involuntary prior to the earliest retirement age or to the named beneficiary upon death. This is commonly referred to as a separation benefit. However, the participant who chooses the separation benefit, i.e., refund of employee contributions, will forfeit the entire Employer account and all future enhancements to the Plan. The Separation Benefit will be discussed later.
Most state retirement systems are designed, or structured, in this manner. That is, having an employee account balance, an employer account balance, two calculated benefits at retirement, and a Separation Benefit, or refund of contributions upon termination. As mentioned, the WRS plan is very much a combination of two types of plans. The defined contribution portion of the plan, similar to a 401(k) or savings plan, is the employee account. As with defined contribution plans, the account balance at any given time is the present value. A defined contribution plan is the type of plan where the contribution is defined today with the annual, or monthly, benefit at retirement left uncertain. Keep in mind, after the earliest retirement age, no lump-sum option is available.
The Plan also has an Employer Account. The Employer Account consists of 100% employer contributions and is an equal amount to the Employee Account. The account, however, is never available to the employee participant in a lump sum. The employer account is only paid to the plan participant in a monthly income option beginning at the earliest retirement age. This typical of the traditional defined benefit plan. Therefore, the employer matching account balance is used only to calculate a monthly annuity option. The Employer Account of the Plan is a defined benefit component of the plan and should be valued like any other traditional defined benefit plan. That is, converting the monthly benefit at a specified retirement age and into a lump-sum present value.
The normal retirement age of the Plan is age 65 for teachers and general employees, age 62 with more than 30 years of creditable service, age 62 for elected officials, age 54 for protective occupation participants with less than 25 years of creditable service, and age 53 for protective occupation participants with more than 25 years of service. Early retirement ages range from age 50, for protective participants, to age 55 for general employees and teachers. Before the attorney can determine the value of the employer, or defined benefit portion of the plan, the employee account must be updated. Again, the employer account balance will be equivalent to the updated employee account.
Updating The Employee Account Balance
Since the Wisconsin Retirement System only provides account balances as of the first of every year, the attorney must, and can, bring those balance(s) up-to-date. The account balance(s) can be estimated quite accurately at any point during the year by prorating the accrued interest, along with their contributions, using the number of days already passed in the year and dividing by 365 days of the year.
For example, assume the participant is a teacher or general employee with an January 1, 1996 employee account balance of $100,000 as of the first of the year, having commenced employment after 1982, earns an income of $3,000 per month, and the divorce date is September 13, 1996. Updating their employee account balance would look something like this:
The interest is added first, as prescribed by the WRS, and in this case participants who commenced employment after 1982 receive a flat 5% interest every year on their fixed account. However, to determine the amount of interest accrued up to any point during the year, the attorney must then apply a pro-rated factor. In this example 256 days (September 13, 1996) divided by 365 days equals 0.7014. Apply this factor to the 5% interest on the entire account balance. That is, the $100,000 will earn $5,000 in interest for the entire year, however, in this case, only 70.14% of the year has expired, or 70.14% of the interest that had been accrued. Therefore, the accrued interest equals $3,507, or $100,000 x 0.05 x 0.7014.
At this point, it is important to note that for those participant who commenced employment prior to 1982, the yearly interest applied to fixed accounts vary, however, the average since 1980 is approximately 11.27% per year. In addition, participants who commenced employment prior to 1982, were also eligible to allocate a portion of their contributions to a variable account that has averaged a rate of return of 14.8% per year since 1980.
In terms of contributions, it too will vary depending upon the type of employment. For example, teachers and general employees contribute 5% of their salary while Police (Protective) contribute 6%, Firefighters 7.2%, and Judges/Elected Officials contributing 5.5% of their earnings. The contribution rate, in this case, is 5.0% per year for Teachers and general employees, and would normally be based on the individual's current monthly salary. In this example, we estimated the year-to-date contributions to be $1,263 by taking $3,000 per month times 12, or $36,000 that individual will earned for the entire year, and multiplied by contribution rate of 5%, or 0.05. Furthermore, we apply the same pro-rated factor determined above, or 0.7014, to $1,800 ($36,000 x 5% x 0.7014).
Often times income figures are not readily available. The attorney could simply use the previous year's contribution as an estimate of the current year's contributions. The difference in the actual contributions made in the current year and the estimate using the previous year's contributions will have a minimal impact in determining the overall present value unless of course there had been a significant increase, or decrease, in the participant's earnings.
Therefore, we have arrived at the value of Employee Account portion of the Plan to be $104,770 and is also the present value of this portion of the Plan. We neither discount this portion of the Plan to present value ,nor for mortality because the entire balance is available upon death or termination of employment in one lump-sum.
The estimate of the Employer Account is equal to the estimated Employee Account portion as stated above since the WRS matches dollar for dollar the employee's account balance. However, theoretically the Employer account balance is used only to determine a monthly retirement benefit, since it can only be receive in annuity form, which then is subsequently brought back into present value terms (defined benefit plan). This figure is then added to the Employee Account portion as determined above and the combined total is then the present value.
What about the employer account? Certainly the participant has accrued some benefit from this portion since WRS equally matches the employee account in contributions made. The employer account again represents the defined benefit portion of the plan and it must be treated as such. Similar to an employee who is employed by a private firm with a pension plan, such as with GM or IBM, there is a monthly retirement benefit that has to be determined and converted to lump-sum present value terms.
Calculating The Monthly Benefit
There are two methods used to determine a monthly benefit under the WRS Plan referred to as the "Formula Benefit" and the "Money Purchase" benefit. The WRS always pays out the greater of the two calculated benefits "at" retirement. The Formula Method, which is based primarily on the participant's earnings and years of service, will usually yield the higher monthly benefit. This, however, is based on the premise that the participant will continue their employment under the Wisconsin Retirement System up to and until retirement. Since we know it is pure speculation as to whether or not the participant would continue their employment while under the WRS, the monthly benefit derived from the Formula Benefit Method would be speculative as well. Therefore, the monthly benefit determination used for this purpose is the Money Purchase method which is derived from, and based on, only the value of the employer account balance. Keep in mind, that the monthly benefits derived from either the Formula Method, or the Money Purchase Method using both account balances, are only applicable at retirement and certainly not when the participant is several years from retirement.
Using WRS Publication ET-4120 for the appropriate factors, the monthly benefit calculation based on the employer account balance only, and for the early and normal retirement ages are as follows:
The present value of the above monthly benefit(s) is then added to the Employee Account to arrive at a present value of the entire WRS. Generally, the overall value is approximately one and one-half times the employee account balance. In this case, the present value is estimated to be $167,700, or $62,930 which represents the present value of the employer portion, plus $104,770, the value of the employee account balance. This is appropriate since, as mentioned previously, the plan is very much two plans in one.
The present value of the monthly benefit would then be discounted slightly for mortality. In other words, there is approximately a 10% probability, in this case, of the participant predeceasing the commencement of their retirement benefits at age 55 or approximately 15% at age 65. The mortality discount is typical in traditional pension valuations for divorce and is applied to the present value multiplying the present value by 1 - 0.10 or 1 - 0.85 for the age 65 present value in this case.
The above present value can be considered the minimum value of this plan and is considered practicable if used for property offset purposes. If a Qualified Domestic Relations Order (QDRO) is imminent, the value of this plan to the participant will equal total of both account balances. In a QDRO, both portions, the employee account balance and employer matching account balance would be divided equally by a specified percentage.
The reasoning behind this approach is that both account balances continue to grow at the stated interest rate regardless of whether or not the participant remained employed under this system. To support this approach, one can simply observe that under a QDRO, and assuming a 50% division for illustration purposes, the non-participant spouse, i.e. Alternate Payee, would receive half of both account balances. Therefore, if it is known that the participant's interest in the plan will be divided pursuant to a QDRO, the value should then be recorded as the total of both account balances.
It is important to note that the separation benefit, employee account balance only, or refund of employee contributions, is not indicative of the present value. The Separation benefit election comes about when a terminating employee elects to withdraw from the system. However, more than 96% of the terminating employees understand that when electing this type of benefit they will forfeit the employer matching account and all future benefits. Thus, most opt to leave their contributions in the system. In other words, statistics made available by the Wisconsin Retirement System reveal that only 4% of the participants who terminate employment within the WRS system take their employee account in the form of a separation benefit upon termination of employment.
We know that an employee who terminates a WRS covered position has the option of maintaining all of their accumulated funds within the system, until they are eligible for retirement, or they may withdraw the funds identified as the Separation Benefit (employee account balance) upon termination. The election of a Separation Benefit by a terminating employee is considered a severe penalty. To reinforce this position, the Wisconsin Retirement System had amended their plan in 1989 to recalculate the accrued interest of a participant's employee account balance to reflect a lower interest rate. To say that the present value is at, or near, the Separation benefit is a gross mis-statement and only tends to undervalue the participant's actual benefit. If an employee participant elects to receive the separation benefit upon termination of employment and roll the proceeds over elsewhere, they will forfeit the entire employer account balance, with interest, and any future benefits from the system.
While it is true that some evaluators may use the formula benefit method for computing a present value, the attorney needs to understand that this method is only applicable at retirement and not when a participant is several years from that time. The point being is the present value, under this method, will often be very close to the separation benefit which again, is regarded as a severe penalty, in effect making the present value of the calculated benefit a severe penalty. These, and other, assumptions can affect the present value dramatically.
Now it is certainly true that the Wisconsin Retirement System utilizes two different methods to determine monthly retirement benefits when the participant applies for retirement. As mentioned, the participant would then receive the higher of the two calculated benefits. The two methods employed are the "Money Purchase Method", a monthly benefit derived from the employee and employer account balances, and the "Formula Benefit Method", derived from the participants years of service, annual earnings, and multiplied by a formula factor.
The present value of these calculated benefits, in most cases and especially when interest rates are at their normal levels or higher, will result in a present value less than the employee account balance. Again the present value could not be less than the refund of contributions upon termination of employment or the employee account balance. There are exceptions. The Formula Benefit Method can be appropriately used if the participant is pension eligible or very close to their retirement date.
The "Money Purchase Method" could be used if the participant is within five to seven years of retirement. Why five to seven years? If the participant terminated their employment prior to retirement, and elected to leave their contributions within the system, it would take approximately five to seven years before the monthly benefit derived from the account balances would surpass the benefit derived from the Formula Benefit Method. This is true since the Formula Benefit Method is based on income and years of service which remains static well after the participant terminates covered employment. Again the present values derived from either of these two methods would only be applicable at, or near, the time the participant reaches their earliest retirement age. Otherwise, the method which calculates a present value based upon the employer account, and subsequently added to the employee account balance, is the method which results in a true value of the plan to the participant.
The Wisconsin Retirement system can be divided by a Qualified Domestic Relations Order. When dividing the WRS plan via a QDRO, the Wisconsin Retirement system will segregate the account balances by a stipulated percentage not exceeding fifty percent (50%). The Alternate Payee will then have an employee account, and an employer account, of their own. In this authors opinion, the WRS division is very equitable. The participant will need to understand that with a division of the account balances, their years of service will also be divided by the same percentage when computing retirement benefits. However, the participant will not lose any of their years of service in terms of eligibility.
With regard to the Alternate Payee, they will have the same options afforded to them under the plan with the exception of making additional contributions or having their contributions matched by the Plan. The Alternate Payee may also elect a separation benefit. What is crucial on the part of the Alternate Payee to understand is that, similar to the participant, an election of a separation benefit would result in a forfeiture of all future benefits and the employer account balance.
Often times, an attorney who may prefer a low present value, where they represent the participant, will argue for the Separation Benefit or refund of employee contributions. This, however, neglects the value of the employer account balance and would be comparable to ignoring the value of a pension for an individual working in the private sector since they too would have to wait sometime before the commencement of their retirement benefits. This approach tends to conflict with the idea or notion that future retirement benefits have any value.
There are those that may argue that the present value is both account balances combined. This second approach, although closer to the true value, can be argued against since there exist a time element where at least some portion would have to be discount for time. An argument for this approach, however, is that contributions made during the marriage will continue to grow regardless of whether or not the participant remains under covered employment. As mentioned in the preceding paragraphs, this method is appropriate if a QDRO is immanent. The approach outlined throughout this reading where, from an economic perspective, the employee account balance is the present value and the employer account balance being converted to a monthly benefit and further discounted for time, offers a more statistically sound approach.
Tim Voit is a Financial Analyst and founder of Voit Econometrics Group. Tim Voit has been involved in researching state retirement system for purposes of divorce while having valued Wisconsin Retirement System benefits as well as plans of surrounding states. Tim Voit has provided expert witness testimony in the valuation of state retirement system benefits in several states including Wisconsin and Illinois. As an affiliate member of the American Society of Pension Actuaries, and a member of the International Foundation of Employee Benefits, Tim Voit, and Voit Econometrics Group, has aided attorneys and law firms in the drafting Qualified Domestic Relations Orders (QDRO's) and other Orders relating to private, governmental, and Military plans. To gain a complete understanding of the Wisconsin Retirement System applies to divorce situations, please feel free to contact Tim Voit at (262) 784-2937, or Toll-Free 1-800-557-8648. https://www.vecon.com. A sample questionnaire/authorization for pension plans can also be made available.
WRS publications are as follows: How Divorce Can Affect Your WRS Benefits ET-4925, Money Purchase Retirement Benefits ET-4120, Separation Benefits ET-3101, Formula Benefits ET-4107, Investment Earnings Distribution Report ET-2124, and Your Benefits at a Glance ET-4101. Life Expectancies and Mortality Rates can be obtained from the Vital Statistics of the United States published by the U.S. Department of Health and Human Services or the Statistical Abstract of the United States published by The Reference Press, Inc.
© Voit Econometrics Group, Inc.