Valuation of tax favored plan benefits in a dissolution, an actuarial perspective

This outline is available on the web at:
 The online outline contains hypertext links to all the handouts.

Brief Introduction.  Here is my resume

Philosophical Issues : Why I don’t do Qualified Domestic Relations Orders (QDRO’s), why I do adhere to the Actuarial Standards of Practice.

Statement of Principles

Actuarial Standards of Practice: what they are, why they are important, and where you can read them for yourself .

            ASOP 4:  Measuring Pension Obligations

            ASOP 17:  Expert Testimony by Actuaries

            ASOP 23:  Data Quality

            ASOP 34:  Actuarial Practice Concerning Retirement Plan benefits in Domestic Relations Actions

Code of Conduct

What kinds of benefits are tax-favored?

Defined benefit pension plans (DB)

Defined contribution plans – not all pension (DC)

Stock options

Employee stock purchase plan (ESPP)

Non-qualified plans, sort of

How to identify defined benefit pension plans

Who has the risk?  Employer

Traditional Plans – benefits derived from a pay or service based formula

“Hybrid” Plans – Cash Balance

How to identify defined contribution plans

Who has the risk?  Employee

Profit sharing and money purchase

401(k), 403(b), 457 plans

ESOPs of all flavors are just profit sharing plans with investment restrictions.

All Flavors of employee stock acquisition plans

Traditional stock options

Stock appreciation rights

Phantom stock

Stock grants

Employee stock purchase plans

What are the elements of a good (useful) report?

Paper is my only product.  Why a good report is preferable to testimony.
Most clients want one answer, not a range of choice.

Disclose everything

Data quality (how much, how informative, how legible, what’s missing, what’s out of date)
Rely on professionals – attorneys and accountants and others – to do “discovery,” provide documents, “encourage” cooperation.
Calculation methods
Distinguish estimates necessary because of poor data from the estimates of normal valuation practice.
What assumptions were chosen, and how, and why? 
Back to the Statement of Principles
Special requests from either party – special valuation dates, adoptions of certain assumptions.  Always give an opinion as to effect of this request (usually with two valuations side by side on the same letter, if possible.)

Make it simple

One letter per topic, plus one summary letter is very effective format.
Makes writing a little more difficult, because you need to cross reference.
Minimal additional effort at this stage reduces phone calls and court visits.
Review Phone Logs occasionally to look for patterns of questions.  Look for indicators that communication needs improvement, especially misinterpretation, misunderstanding or perceived ambiguity in wording.  Develop “bullet proof” standard language for standard situations. 
“Idiot-proof” is impossible.  Someone is always inventing a smarter idiot.  But most judges and attorneys are NOT idiots.  Rely on the professionals for management of unruly or uncooperative clients.  When the professionals “get it”, they are our best ally.
Even if “it goes without saying,” don’t let it.  Never make assumptions about what is obvious, what follows logically, what everyone knows.  If you are relying on a particular shared attitude or assumed background information, state it clearly and unambiguously.
Respect English as a second language issues.  It is possible to communicate effectively without “dumbing down” content.  It just takes a little more work.

Make it pretty

Careful organization – use a pyramid (extreme case example)

Cover letter – salutation, describe the engagement, tell what’s coming, give attaboys for special assistance.
Sometimes table of contents is necessary, but tabbed binder is usually better.
Summary – present a list of reports, put together a summary of each report, present an “offset” or one final net calculation showing a single sum which is equivalent to all the others combined, if possible.  If there are significant qualitative differences among the assets, an offset may not be reasonable.
Sometimes two or more summaries are necessary.  For instance, one for tax deferred assets and one not.
Individual letters, roughly one per topic – DB Plans, DC Plans, Options, ESPP, non qualified plans.  Alternative organization – one letter for each spouse.  If possible limit these detail letters to less than five pages, not including attachments.
Use attachments to individual letters.  Where appropriate, give detail of contributions so calculations can be checked by those so inclined.

Assume the report will undergo a 100% immediate audit by each recipient.

Use lots of headings, italics, and bold to highlight topical structure, unusual and important issues.

Use lots of clearly labeled tables to logically separate and emphasize key issues, and make them easy to find.

Use white space to give visual clues regarding sections, topic changes, logic flow.

Redundancy is OK, even desirable.

Footnotes provide detail without interrupting the flow of logic in the body of the report.  (I often use footnotes to present the explicit formula of a calculation).

Include the details of calculations where they can be understood and even checked manually (lots of engineers around the Silicon Valley)

These are not trade secrets!  Disclose, Disclose, Disclose!

Case Study 1:  The following three letters all relate to the same case.  This is a typical set of multiple reports.  Wife is still working at STRS and has one letter about her pension plan.  Husband is retired and receiving monthly payments.  He has his own letter.  Then the summary calculates one offset amount either for sharing the pension payments or to enable husband to buy out the other wife’s interest.

Summary Letter for Active (Wife) and Retired (Husband) Couple

Letter for Active STRS Employee

            Letter for Retired Employee

Valuing a Defined Benefit Plan

What do you need to know to value a traditional defined benefit plan?




(DOT or DOR)



(part-time or interrupted service)

Current RATE of pay

(some union plans, old telecomm industry, $ per year rather than % of pay)

(Teamsters – hours of service reports)

Current Summary Plan Description (SPD), all Summaries of Material Modifications (SMMs) since SPD was issued.

Why do you need all this stuff?

Goal is to determine maximum value to the community.

Why?  Because effective negotiation cannot occur if one partner is hiding the ball.  Partners can agree to take less that maximum as an accommodation to the other spouse, but concealing or omitting a potentially larger benefit value – even inadvertently – is just asking for a lawsuit.

Calculating the maximum value to community requires identifying discontinuities and boundary conditions in benefit formula

Earliest retirement age

Unreduced retirement age

Normal retirement age

Vested deferred benefits vs. projected benefits

Sample letter for vested deferred benefit

COLAs and ad hoc adjustments

Social Security leveling options

Calculating the benefit at each alternative retirement age is the most difficult part of the DB valuation process

What if the benefit is already in pay status?

You need to know the form of annuity elected.  Is it some percentage joint and survivor?  Is it over some period certain?  Who is the beneficiary?  Is there a death benefit for the spouse?  Which spouse?

All DOBs, wife I, wife II, girlfriend, kids, whoever

History of payments already received.  Is payment being shared now?  Garnishment not available, only QDRO division.

(Why social security benefits are always separate property).

Arrearages (& interest thereon) are handled separately from future payments (10% simple required?)

Value each component separately – while both are alive, if participant outlives spouse, if spouse outlives participant.

            Sample letter for benefit in pay status

After you get all this stuff, what do you do with it?

Calculate benefit at all discontinuities.

Select assumed retirement age.
SS integrated plans – read document  carefully.
How calculate Primary Insurance Amount (PIA)?  SSA web site has three kinds of calculators .
“ quick,” which requires that you know one year of compensation,
“online” which requires compensation history,
       “detailed” which requires you to download their program, (and keep it current every year), gives wide range of estimation options, including salary projections backwards and forwards, disability benefits, interrupted service, spouse and dependent benefits, different retirement ages .  Here’s an address where you can find all three calculators:

How do you calculate Covered Compensation?  Don’t try.  Look on the web.  IRS and other web sites have them for current years.  Here is 2005:

Select an interest rate

Actuarial Standards of Practice requires the determination of a risk free return, such as high grade or government bonds of comparable maturity to the liability.
“Comparable” Maturities
Apparent vs. actual precision

Relative importance

   Usually the selection of an interest rate is the single most important assumption for any actuarial valuation.
Interest Rate Comparisons at various ages, with selected charts

Select a mortality table

Where do they come from? SOA publishes some, IRS and Bureau of Census publish some.  For Instance:

How many are there, and why are there so many?

How do actuaries compare different tables? We use “Expectation of Life”.  Identical to a life annuity with zero interest rate.

Example:  Comparison of Population Mortality Tables based on 1900, 1950, and 1990 census

Example:  Comparison of Expected Lifetimes from tables built for different purposes

Selection Criteria

Healthy active lives (blue collar, white collar)
Healthy retired lives(also differ by “collar”)
Disabled lives.  How you can  use a standard table to approximate a retired life?
Maximizing the value to the community.  Maybe the non-participant spouse should get all of the retirement benefit.

Relative importance

Determining various potential retirement ages and the benefits at each of those ages

Salaries – to project or not to project
Vesting – how relevant
Participant assertions as to retirement age
Calculating the lump sum present value
Very few plans actually pay out a lump sum – but it gives the parties a means of comparing to other assets.  (She gets the house; he gets the pension, for instance.)
Multiple calculations may be needed to determine that you have actually found the maximum value.

How to incorporate a COLA?

How to incorporate SS leveling option?

Reality check regarding retirement age assumption

Repeat as necessary – Often necessary to run multiple possibilities to make sure you have the maximum.

Why not use the plan’s actuarial valuation assumptions?

Refer to my statement of Principles

Can you estimate the value of a life annuity by using an annuity certain for expected lifetime?

Annuity certain to Life Expectancy will always overstate the value.

Cash Balance Plans

Different from traditional DB plans:
·        generally pay as a lump sum,
·         may have very early retirement ages,
·         employer assumes risk, but it is communicated differently – as guaranteed salary credits and guaranteed interest return.
SPD should disclose guaranteed interest rate, or method of computation.
SPD should disclose salary credits.
Whipsaw valuation problem – IRS requirements
Problems – no determination letters, weird provisions (e.g. B of A permits transfers from 401(k) accounts)
Sometimes have to value as DC plan due to data limitations, but these are not DC plans.
Projecting future interest credits – already accrued when salary credit is made!  Some employers try to lower interest rate assumption for terminated employees.  IRS does not approve.
Where possible, just QDRO it and don’t attempt a valuation – too many unknowns, including viability within tax code, age discrimination, improper conversions, incorrectly calculated payouts, fake retirement ages, congressional displeasure are all risks.

Valuing a Defined Contribution Plan

The intent is to determine beginning and ending balance and all contributions and earnings.

Example of Spreadsheet for 401(k) plan with irregularly issued statements

Determine your starting point!

Need to find a starting date on which it is known that the entire account is either 100% separate or 100% community, or some other date when is agreed by the parties that the relative proportions of community and separate property are known . You must have a starting point because DC plans are traced.  You may have to use the “time rule” to allocate the beginning values, but it’s a poor estimator with unknown bias.

Determine period for which each contribution applies.

Contributions can be allocated to community property or separate property based on marital status relating to period for which they are made.  Watch out for plan contributions made after a plan year end (up to 8-1/2 months after PYE) which refer back to or are based on comp in a prior period.

Determine Earnings for period

Earnings should be allocated in proportion to beginning balance plus a pro-rata  (usually half) share of the contributions during the period, depending on average time on deposit

Allocate Period by period

This is a standard method which correctly estimates changes in community property and separate property over SHORT periods of time
Monthly and quarterly statements are ideal, or irregular periods up to 1 year are OK, longer periods are so-so. 
if there are withdrawals as well as contributions, there is a theorem in financial math which proves the ROI is not unique.  YOU SHOULD NOT USE THIS METHOD OVER A PERIOD LONGER THAN A YEAR if it includes funds flowing both in and out.
Case Study 2:  Egregious Errors Due to Reality Check Failure

Memo Discussing Lack of Reality Check

How handle employee loans?

Typical case:  Loan is joint liability, payments being made by participant spouse from payroll deduction.
Determine loan balance as of DOS – half of this amount must be credited to participant spouse.
Payment on loan should be split into principal and interest.
Principal must be used to rebuild community share of account.  That’s where it was borrowed from!
Interest is part of the earnings for the period.
Amortization table is useful, if there is one, or if you can calculate one from original note terms, so you can separate the principal and interest components of each payment.
Some plans already do this for you in their quarterly statements.  Be careful not to double count.

Data Quality:  The right way

Was participant in plan before marriage?

Yes: ask for ALL statements since last valuation date prior to marriage up to the present time.
No: ask for ALL statements since last valuation prior to (earliest) separation date up until the present time.
If various other accounts rolled in or rolled out, get relevant history – employer, dates of hire and termination, date and amount of rollover, separate account?

Data Quality:  The realistic way

Lots of scope for creativity here.

Get as many statements as you can.
One or two missing can usually be finessed – average prior and subsequent contribution rates (watch out for number of months), earnings to balance.
Some statements have “year to date” or “since inception” information which will allow you to back into the contributions, then use earnings to balance.
W2s will tell you participant contributions.  Might be able to estimate employer match.
Get statements as far back as possible, use time rule on beginning balance, then trace forward in the usual way.
Case Study 3:  The dollars per day on deposit approach

Letter describing unusual method which makes maximum use of available data

Spreadsheet illustrating above

The key here is FULL disclosure. 

Calculating an offset

When is an offset a good idea?

·        When there could be a trade for another asset (such as an interest in the residence)
·        When parties desire to minimize number of QDROs (cost and complexity)
·        When there is a DC plan which will pay non-participant a lump sum, and she can roll to IRA (tax free) or dispose (early disposition penalty may not apply)
·        When there is an IRA large enough to make trade worthwhile.  IRA transferred “in connection with a marital dissolution” does not require a QDRO, but be careful.  Timing is everything.
·        When parties understand qualitative difference between types of benefits (e.g. DB with or without COLAs, DB vs DC, tax favored vs. sell the house)
Try to explain the risk transfer.  (Participant spouse is selling risk of future employment, eventual benefit maturity; non-participant spouse is buying flexibility, losing all other guarantees.)

When is an offset a bad idea

·        When a plan is known to be in trouble and likely to be terminated (UAL Pilots, ground employees)
·        When parties cannot agree to an offset because of qualitative differences
·        Where the parties want division in kind
·        When a (usually a union) plan gets frequent, substantial ad hoc benefit improvements which apply both retroactively and prospectively but irregularly, so cannot be anticipated and quantified
·        Cash balance plans

Example of offset:  Summary Letter from Case Study 1

Stock options and employee stock purchase plans

Methods of valuing stock options

Common Methods

Nelson:  options awarded to reward past service and encourage excellence in expected future service.
Hug:  inducement for employment, “sign-on bonus”.
How big is the difference?  Is it worth fighting over?  (Sometimes non-participant spouse will allege Hug for entire employment period.)

Uncommon methods

Other valuation methods get proposed occasionally,  e.g. the “Sequential” method used in “Marriage of Short” from Washington State.
Case Study 4:  Valuation of Employee Stock Options

Sample Letter For Option Valuation showing both Nelson and Hug

Sample Spreadsheet showing calculations for Nelson and Hug

Memo Regarding Defense of Hug and Nelson Valuations, vs Sequential Method

Black Scholes and Lattice models.  Generally used by companies to value employee compensation attributable to stock options.  Generally not appropriate for dissolution valuations.

What if stock is not publicly traded?

Transfers to non-participant spouse not usually feasible.
Consider asking parties and their attorneys to set share price (such as in a business valuation).  If everybody agrees, go with it.  If a range is suggested and agreed to, value at high, low, average, and let the judge decide.
Division in kind with reserved jurisdiction.
Get an appraisal – potentially very expensive.

Effect of taxation on option exercise and allocation. 

Methods of valuing employee stock purchase plans.

Determine period over which salary withholding has occurred – 3 months to 2 years! 
Pro-rate share purchase (“new” holdings) between separate property and community property based on # of days married during withholding period.
Treat bargain purchase element as earnings, but allocate to “new” stock, same as share purchase
Treat stock dividends and cash dividends as earnings and proportional to “old” holdings
Balance number of shares as well as dollars
Look out for unusual provisions – (e.g., HP’s 50% bonus shares after 2 year holding period)

            Here is a sample spreadsheet for an ESPP

Non qualified plans

Generally considered part of the community property, but may be difficult to extract benefit for non-participant spouse

Cannot use QDRO.
Spendthrift clause may prevent attaching assets.
May be unfunded, existing only on the books of the employer.
Always taxable to participant  spouse.
Report organization same as for comparable qualified plans, except for discussion of tax issues.

“Top Hat” Plans – limited to officers, highly paid (Participant spouse usually has lots of clout with Employer)

All kinds of provisions, funded or unfunded, risky or risk-free, generally onerous tax consequences if distributed to non-participant spouse.
May be willing to pay as lump sum.
May not be willing to pay at all.
Study documents, determine if risks are measurable.
If not, recommend trade for other property, or division when received.
Not a qualified plan, so cannot use a QDRO.

“SERP” Plans – generally pension supplement if regular plan benefits are limited by Section 415 of the tax code.

 Basic plan benefit cannot exceed 100% of highest 3 consecutive years W-2 Pay.  Pay limited to $210,000 this year.
Benefit cannot exceed dollar limitation - $170,000 this year at age 62 to 65, less if earlier retirement age, more if later.
SERP plan typically “fills up” benefits for employees whose qualified plan benefit would otherwise exceed 415 limits.
Valuation methods basically the same as for the underlying plan to which this is a supplement.
Taxation and disgorgement is still a problem – cannot use QDRO because plan is not qualified.

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© 2005 Patricia P Watt.  All Rights reserved