|Are Pension Benefits Really Worth More in Divorce?
While 401(k) account values have plummeted, the calculated value of pension plans get a lift from reduced interest rates.
March 19, 2009
For most couples in divorce, the retirement plan accounts are a large portion of their wealth. As they look at their net-worth statements and contemplate how to best divide the property, they are looking at shrunken values of their defined contribution (DC) plan account balances. When it comes to their pension benefits, it is a bit trickier to determine the values. Coming up with today's value of a pension involves some complex mathematical thinking. Usually a CPA or an actuary is hired to do the heavy thinking. These days the calculated value for a pension will generally show a higher value than it might have shown in prior periods.
Many assets can be divided in divorce by either splitting or offsetting. The classic offset concept is "You get the house and I get the retirement." In the context of this article, it might be "I get the 401(k) and you get the pension." Instead of using an offset method, splitting the 401(k) account and the pension would entail allocating 50 percent (or some other agreed upon percentage) to each spouse so that each one walks away with a portion of both retirement accounts.
In an offset situation, imagine an empty bucket. The nonparticipant spouse needs to fill that bucket with cash, then invest that cash at a safe interest rate and, years from now at retirement age, get a monthly check that is the equivalent of the monthly pension check they would have received had the couple opted to divide the pension instead of offsetting it with other assets, such as the 401(k) account. The cash in the bucket represents the present value of the nonparticipant's share of the pension benefit.
There are five basic factors that influence the calculation of the present value of the pension (the resulting amount of cash to put in the bucket). They are the:
There are other not-so-basic factors that influence the valuation, but in this article, I am confining myself to the interest rate effects on pension valuations in divorce.
U.S. Government bond rates are ideal for valuing pension plans in divorce, because they are the only rates that are guaranteed to span over long periods of time. Actuarial Standard of Practice No. 34 states that, unless another assumption is clearly warranted by the facts and circumstances, an interest rate for valuing retirement plan benefits in domestic relations actions should be a low-risk rate of investment return. Various pension experts suggest the 30-year or 20-year U.S. Treasury Bond Constant Maturity Rate for the month of the valuation date. There is an inverse relationship between interest rates and present values. A lower interest rate results in a higher present value and a higher interest rate results in a lower present value. Between October 2008 and December 2008, the 20-year U.S. Treasury Bond constant maturity rates slid to the extent that a pension valuation in December would result in a valuation that was 60 percent greater than the same valuation would have shown in October. So, while DC plan accounts such as 401(k) plans are plummeting in value, calculated values for pension plans are rising. As you can imagine, the value can drop just as quickly.
In my opinion these pension valuations are mathematical calculations of a "what if" situation. What if the nonparticipant spouse were to invest money now to generate a certain payout at retirement? There are many assumptions built into the calculation. Changes in assumptions can materially affect the calculated value. This is not to say the valuation exercise is not useful. It is very useful to give the divorcing couple an idea of the value of a pension. But, just like 401(k) accounts, there are no guarantees that the desired result at retirement age will, in fact, exist as hoped for.
Impact on Divorce Negotiations
When a couple is struggling with how to divide their assets during their divorce, they need to understand the nature of those assets. If their retirement accounts include pension benefits, they need to understand how to compare their pensions to their DC plan accounts. The 401(k) plan account value is printed on their broker statement. The pension benefit value is difficult to calculate and difficult to understand. In a litigated divorce, they could spend a fair amount of money and time fighting over the calculated pension value. In a recent collaborative divorce case, a couple was not comfortable valuing a pension under the current financial crisis. So as not to be unduly influenced by what we all hope are temporary conditions, they considered a calculated present value at various interest rates from the past 10 years. They agreed on a value and plugged it into their negotiations. The beauty of the collaborative process is in providing couples the ability and encouragement to think in creative ways to make decisions and agreements that personally fit their situation, goals and desired outcome.
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Tracy B. Stewart, CPA, PFP, CFP, CDFA specializes in family law litigation support in Houston, TX. She helps clients protect their wealth during property settlement negotiations. She is a member of the AICPA Personal Financial Planning and the Forensic and Valuation Services sections. Stewart is a board trustee for the Collaborative Law Institute of Texas as well as on the Executive Board of Texas Society of CPAs. You can contact her through www.texasdivorcecpa.com.