How To Value A Defined Benefit Pension For Divorce
DB pension valuation, with an example of a FERS pension
|Written by Tom Yeung, CFA | CDFA|
Investment Advisor & Fund Manager, Jurnex Financial Advisors
In this article, we cover how to value a defined benefit pension plan for divorce.
According to the Department of Labor, 26% of Americans with a retirement plan still have a defined benefit plan. What are these plans?
- Defined Contribution Pension (DC). Each participant has a separate account, and values are easy to calculate, i.e., 401(k), 403(b), and TSP plans.
- Defined Benefit Pension (DB). Each participant receives a pension from a pooled account based on their years of service and other factors, i.e., FERS, teacher’s pensions, and military pensions.
How to divide a defined benefit pension in divorce?
There are three methods to dividing defined pension plans in divorce.
1. Present value (cash-out) method. The non-employee spouse receives a lump-sum settlement from the pension or receives a like-for-like marital asset of equal value.
2. Deferred division (future share method). No present value is determined. Instead, each spouse gets a share of the benefits if and when they’re distributed.
3. Reserved jurisdiction. The court retains the authority to distribute the pension plan at a later date.
Present Value method has significant advantages
The first method allows spouses to part ways with no future obligations. The non-employed spouse immediately receives an equivalent asset, while the employed spouse is free to enjoy his or her full retirement benefits. Deferred Division and Reserved Jurisdiction leave the power and obligation with the employed spouse and the courts, respectively. These options can leave the couple with future debt obligations, or the employed party can delay retirement to the detriment of the non-employed one.
How do you value a defined benefit pension plan?
In the next section, we’ll cover the nine steps to performing a proper valuation of a defined benefit plan. If you are performing this calculation as a property settlement agreement, I highly recommend you reach out to me or another qualified financial analyst to perform or verify your findings. That’s because pension values can make up a significant portion of marital assets. But to get you started, here is a seven-step guide to valuing a defined benefit pension plan for divorce.
1. Calculate current benefits
When valuing a defined pension plan in divorce, the common practice is to assume the employee leaves TODAY. That’s because once a couple separates, all future benefits are considered separate property, not marital.
So let’s assume an employee, Robert works in the federal government and is enrolled in a FERS defined benefit plan. He is currently age 55 and has worked in government for the past 15 years.
According to the Office of Personnel Management, the FERS Basic Annuity Formula is as follows:
Based on his high-3 salary and years of service AS OF TODAY, we calculate Robert is eligible to receive $4,500 per month at age 65
2. Calculate life expectancy
Next, we look up the employee’s life expectancy in retirement. The CDC Life Tables, published annually under the National Vital Statistics Report, provide a good baseline.
(The Society of Actuaries also publishes mortality tables, although these are typically used for pricing insurance products rather than calculating life expectancy.)
According to the CDC tables for US males, Robert’s current life expectancy at age 55 is 26.05 years. Therefore, his life expectancy at age 65 will be 26.05 – 10 = 16.05 years.
3. Determine the appropriate discount rate (discount factor)
Because defined benefit plans consist of FUTURE cash flows, we need to adjust all future benefits to reflect their value today. In other words, $100 in 30 years is worth less than $100 today.
Therefore, we need to apply an appropriate multiple to convert future cash flows to today’s values. These multiples are known as “discount factors” and are linked to current interest rates and return expectations.
Guidelines for choosing the discount rate
The Government Accountability Office (GAO) publishes guidelines for choosing discount factors.
However, choosing the right rate can be complex. Why? The GAO leaves it up to individual entities to select the exact discount rate multiple. And this flexibility can cause extreme distortions in pension valuation.
For example, DC teachers currently use a 6.5% discount rate, while Texas County and District use an 8.0%. The difference is astonishing: after 30 years, a DC pension will look 52% LARGER than a Texas County one, simply because of their discount rate.
That’s why it’s essential to select the correct discount rate when calculating the value of a pension.
In the case of Robert, his FERS plan falls under Public Sector plans. Therefore, according to the GAO, we should use the Generally Assumed Return as the discounting premise.
The Office of Personnel Management (OPM) publishes and updates economic actuarial assumptions used by both FERS and CSRS. The most recent assumptions use a 4.25% return on investments.
As a side-note, there is a strong argument that federal return assumptions are too low, given that most state pensions use between a 6.5-8.0% with an average of 7.2%. While the difference partially reflects the very low risk of Federal bonds, academic research also suggests that long-dated bonds are artificially cheap thanks to legally mandated demand from insurance companies.
Therefore, there is some merit in using a “blended” rate of CSRS and State returns. However, in Robert’s case, we will use the generally accepted guidelines for illustration purposes.
4. Calculate inflation adjustments, if applicable
Most defined pension plans include an annual adjustment factor to keep up with inflation. The adjustment factor will influence the discount rate.
In Robert’s case, both the FERS system and Civil Service Retirement System (CSRS) provide a mandated Cost of Living Adjustment (COLA). The short-term COLA is currently set at 1.6%, while the long-term COLA is currently set at 2.0%. Robert should use long-term COLA since he is still employed.
Robert’s inflation-adjusted interest rate will, therefore, be (1 + 5.75%) / (1 + 2%) – 1 * 100 = 3.67%
5. Include a risk discount
Of the 200 largest corporate defined benefit plans in the US, 186 of them aren’t fully funded. In other words, if the plans were liquidated today, they wouldn’t have enough assets to pay their obligations.
Government pension plans aren’t much better. According to the Tax Foundation, states have a combined $1.4 trillion in pension plan deficits. For instance, Maryland and Virginia’s plans are only 65% and 72% funded, respectively.
Some pensions are at greater risk of cutting benefits
The funding deficit means that some pension plans are at greater risk of cutting benefits than others. Recently, the Treasury Department even allowed a Cleveland pension plan to cut benefits for CURRENT retirees. Benefits fell by an average of 20%.
While many divorcing couples choose NOT to add a risk discount factor, failure to do so can overvalue certain pensions. For example, a defined benefit pension from KMart/Sears is worth LESS than a pension from Microsoft, even if both promises to pay out the same dollar amounts.
Risk discounts can either be calculated from bond yields or by calculating the % of the underfunded pension.
In Robert’s case, the FERS system is fully funded, according to the CSRF. Furthermore, the Federal government’s “Aaa Stable” bond rating from Moody’s both suggests either a zero or a de-minimus risk discount factor.
6. Calculate the value of the pension
For the next section, you will need a good financial calculator or a spreadsheet that has a present-value solver. (Older analysts and actuaries might use the venerable HP-12C calculator, while younger analysts might use Excel or the TI-BA II.)
For Robert, we enter the following:
- PMT = 4,500 (monthly amount)
- N = 192.6 (16.05 years in months)
- I = 0.354 (3.67% interest rate converted into monthly)
- FV = 0 (no residual value at the end of plan)
Solving for PV in beginning mode, we find that the value of Robert’s pension will be $656,237.42 when he retires at age 65.
Next, we discount the value of Robert’s future pension into today’s dollars:
- PMT = 0 (no monthly payment while still working)
- N = 10 (years to retirement)
- I = 4.25 (no inflation adjustment)
- FV = $656,237.42
Solving for PV, we find that the value of Robert’s pension value today is $432,813.06
7. Divide the pension
Finally, we need to calculate how much of the pension is marital property vs. separate property.
- 100% marital property. If the couple was married for the FULL length of employment, all pension benefits are considered marital property. Community property states will divide the assets 50-50, while equitable states will divide it equitably.
- Part separate, part marital. If one spouse started accumulating pension benefits BEFORE marriage, part of his or her pension plan would be considered separate property.
To calculate the percentage of marital property vs separate property requires a coverture fraction:
In Robert’s case, assume he has been married for 12 years, but working at his job for 15 years. That means 80% of his pension is marital property, or $432,813.06 * 0.80 = $346,250.44. If his spouse were entitled to half of that, the amount comes to $346,250.44 / 2 = $173,125.22
8. Calculate applicable taxes
Many people are surprised to learn that pension benefits are treated as taxable income. In other words, both Social Security and any pension benefits will be taxed.
Therefore, any like-for-like transaction either needs to be done with:
- Pre-tax assets (deferred tax). Couples can exchange defined pension benefits with traditional 401(k), 403(b) or other assets with deferred taxes in a like-for-like transfer
- Adjusted post-tax assets (cash). Couples can calculate the after-tax value of the pension plan by deducting expected Federal and State taxes
In Robert’s case, a $4,500 pension income per month in his current state of residence will trigger a 14.1% tax rate (excluding FICA taxes, which retirees are generally exempt from paying). The two parties decide to allow Robert to keep the full pension benefits in exchange for cash. The cash amount due to the other party is (1 – 0.141) * $173,125.22 = $148,714.56
9. Choose the best option
After you have calculated the value of a defined benefit pension, you may want to compare the result with the following options:
- Annuity. Often, a privately-bought annuity can be a good alternative if the non-employed spouse wants to secure lifelong income.
- Immediate cash-out. Some private pension plans allow older separating couples to immediately leave the pension plan.
- Future lump-sum. Many plans allow the employed party to receive a single lump-sum payment at retirement.
Finding the value of a defined benefit pension plan for divorce involves multiple steps. And getting the value right can be critical in helping couples come to an equitable settlement agreement.
Yet, the benefits of performing a like-for-like exchange can bring significant benefits to both parties in a separation.
- Employed Spouse. The employed spouse will have free and clear access to their defined benefit plan
- Non-Employed Spouse. The non-employed spouse will receive an immediate cash benefit, rather than being contingent on when the employed spouse decides to retire.
That’s why finding a good valuation for a defined benefit pension plan can be an essential step in helping separating couples move on.
Where to find more resources
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