Valuation of tax favored plan benefits in a dissolution, an actuarial
This outline is available on the web at:
outline contains hypertext links to all the handouts.
Philosophical Issues : Why I don’t do Qualified
Domestic Relations Orders (QDRO’s), why I do adhere to the Actuarial Standards
Actuarial Standards of Practice: what they are,
why they are important, and where you can read them for yourself .
4: Measuring Pension Obligations
17: Expert Testimony by Actuaries
23: Data Quality
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)
Employee stock purchase plan (ESPP)
Non-qualified plans, sort of
How to identify defined benefit pension plans
Who has the risk?
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
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
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legible, what’s missing, what’s out of date)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.
Distinguish estimates necessary because of poor
data from the estimates of normal valuation practice.
What assumptions were chosen, and how, and
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
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
“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
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
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
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.
Letter for Active (Wife) and Retired (Husband) Couple
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
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
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,
History of payments already received. Is payment being shared now? Garnishment not available, only QDRO
(Why social security benefits are always separate
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,
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.
Apparent vs. actual precision
the selection of an interest rate is the single most important assumption for
any actuarial valuation.
Select a mortality table
Where do they come from? SOA publishes some, IRS
and Bureau of Census publish some. For
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
Healthy active lives (blue collar, white collar)
Healthy retired lives(also differ by “collar”)
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.
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
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
to my statement of Principles
Can you estimate the value of a life annuity by
using an annuity certain for expected lifetime?
certain to Life Expectancy will always overstate the value.
Cash Balance Plans
Different from traditional DB plans:
generally pay as a lump sum,
very early retirement ages,
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.
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
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
Lack of Reality Check
How handle employee loans?
Loan is joint liability, payments being made by participant spouse from
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
Principal must be used to rebuild community share
of account. That’s where it was borrowed
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
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
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
Stock options and employee stock purchase plans
Methods of valuing stock options
options awarded to reward past service and encourage excellence in
expected future service.
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.)
Other valuation methods get proposed
occasionally, e.g. the “Sequential”
method used in “Marriage of Short” from Washington
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
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
Division in kind with reserved jurisdiction.
Get an appraisal – potentially very expensive.
Effect of taxation on option exercise and
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
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
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
May be willing to pay as lump sum.
May not be willing to pay at all.
Study documents, determine if risks are
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.
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.
Here’s the commercial at the end of the broadcast:
The ASPPA is currently developing a certification and credential for
financial advisors who sell into the pension market (QPFC). You can learn more about this program at:
© 2005 Patricia P Watt. All Rights reserved