Dividing a pension plan in a divorce

Defined contribution pension plans

Defined contribution pension plans are fairly easy to divide between the parties in a divorce, although care must be taken to avoid unforeseen tax consequences. The division of these types of plans can be as simple as the pensioner instructing the pension plan administrator or financial institution to transfer funds to a retirement account established by his or her spouse.

In other cases the pension plan administrator may require an order from a court before any division or distributions are made.

Defined benefit pension plans

Defined benefit pension plans do not have funds that can be readily divided since they are essentially promises to pay sums in the future. And (perhaps inevitably) opposing experts will choose to place a value on cost of living increases (or not) or select a wildly speculative interest rate or select a retirement date that is highly optimistic. Differences in these assumptions can lead to widely disparate present values of the same pension.

In negotiating a marital settlement, an assessment of the value of the plan as a part of the marital estate is warranted. That is, a simple question should be asked and answered: Are there sufficient assets in the marital estate to trade for the pension plan? Often, the family residence is the only asset with sufficient equity to enable an offset. This is problematic if the spouse that is to receive the residence cannot afford it. It is also a problem if the required payment to the spouse takes all of the current assets (such as cash) from the marital estate or requires the spouse with the pension plan to incur substantive debt to pay the offset.

In some cases, an offset is possible. In others, a reasonable payoff of the pension plan is not feasible. In those cases, it is necessary to divide the pension in the future instead of the present. This means that the future payments of the pension plan are divided instead of the present value.

When pension plans are to be divided in the future, there are several aspects of the plans that should be addressed as part of the Qualified Domestic Relations Order (QDRO) process. The first is the percentage of the plans that will be awarded to the spouse. Assume that a husband and wife have been married for 20 years and that the husband had been accumulating pension benefits for 25 years. The formula for the division of pension plan benefits is normally accomplished through the use of months. This means that the formula for the division of the benefit would function as follows:

Months of marriage 20 x 12 – 240
Months of employment 25 x 12 = 300
Marital portion of pension 240 ÷ 300 = 80%
Wife’s percentage of pension 80 x 0.5 = 40%
Husband’s monthly pension benefit $1,500
Wife’s portion of pension $1,500 x 0.4 = $600

Note that the formula used here assumes that the wife will be receiving 50% of the monthly pension benefit. This may or may not be true. The amount is negotiable or may be decided by a court in a determination of equitability.

Note also that if the pensioner is still accumulating pension benefits, the number of months of employment will increase. This means that in order to preclude the wife from receiving benefits that are earned after the termination of the marriage, the percentage of months of marriage to months of employment must change. Consequently, the QDRO will contain language similar to, “The wife will receive 50% of the product obtained by multiplying participant’s accrued benefit at retirement by the ratio of the months of Plan participation during marriage, which is 240 months, over the total number of months of Plan participation.” This allows the percentage to change as benefits are accrued. In other words, the numerator (240 months of marriage) will not change as the denominator (months of employment) goes up, making the percentage of the total that the wife will get go down. However, since the total amount of the pension is increasing, the wife will still get her fair share of the plan payments.

Another consideration in the assignment of future benefits is the longevity of the parties. On the average, women outlive men by approximately seven years. This means, for example, that if a pension is based solely on the life of the husband, the wife will be without pension benefits when the husband dies. As an alternative, the couple can agree (or a court can order) that a survivor benefit be purchased for the wife. This means that the total pension amount will be reduced in order to cover the cost of covering the wife for the rest of her life. The cost of the additional coverage can be born by both parties. In that case the survivor benefit is elected and the parties split the reduced pension amount. In other cases, it is reasoned that the wife is actually buying insurance for herself and that the reduction for the survivor benefit should only be assessed to her. The following is an example of a calculation and proof of that concept:

Formula for Pension Division – No Survivor Coverage Example

+ Months of Marriage 204
÷ Months of Employment Service 253
= Marital Estate Percentage of Pension 80.63%
x Monthly Pension Amount 1,643
= Marital Estate Portion of Pension 1,325
x Marital Estate Division Percent (@ 50%) 50%
= Pension Payment to Spouse 662

Survivor Coverage Example

+ Monthly Pension Amount – Single 1,643
- Monthly Pension Amount – Survivor 1,320
= Cost of Survivor Coverage 323
+ Pension Payment to Spouse – Single 662
- Cost of Survivor Coverage 323
= Pension Payment to Spouse 339

Proof

Payment to Pensioner – No Survivor Coverage
+ Monthly Pension Amount – Single 1,643
- Pension Payment to Spouse – Single 662
= Pension Payment to Pensioner – Single 981
Payment to Pensioner – With Survivor Coverage
+ Monthly Pension Amount – Survivor 1,320
- Payment to Spouse – Survivor 339
= Payment to Pensioner – Survivor 981

In cases where a survivor benefit is not elected, a question can arise as to what happens if the wife dies before the husband. Since the benefit is dependent on his life, it continues to be paid after she dies. If a provision is not made for the payments (e.g., the husband will receive them), they are made to the estate of the wife until the husband dies.

There are several advantages to dividing defined benefit pension plans in the future by means of a QDRO. First, the pensioner does not have to immediately come up with the cash or assets necessary to pay off his or her spouse. Second, speculations concerning the date of retirement become unnecessary. Third, estimating cost of living increases that may be made by the pension plan do not have to be estimated. Any cost of living increases would automatically flow to the beneficiary’s spouse by means of the division formula.