Dividing defined benefit pension benefits in a divorce strikes fear into the hearts and minds of divorce attorneys. Defined benefit pension plans, often simply called pensions, are far more complex than the relatively newer defined contribution plans like 401ks and ESOPs. Defined contribution plans are often easy to divide in a divorce. They maintain records of individual accounts on behalf of plan participants with records of account activity. Most defined contribution plans use a daily valuation. The account value can in determinable on specific dates, such as the date of marriage, separation and divorce.
Defined benefit plans do not make things so easy. In a defined benefit pension plan the funds remain in a general trust. The plan pays benefits accrued by employees. The plan determines benefits on the basis of plan formulas and adjusts them based upon the plan’s payment methods and age. Understanding the plan rules precedes dealing with any of the family law issues in the divorce.
Misunderstanding defined benefit plans in a divorce can cause harm to both parties. In my time working employer-side in the employee benefits industry I saw QDROs overlooking key provisions and costing the alternate payee–the party receiving the divided share of the account–thousands in lost retirement benefits. Defined benefit pension QDROs should not be drafted by anybody but an attorney well versed in defined benefit plans. However, the battle over defined benefit plan benefits begins well before the QDRO. It is important for a party or attorney approaching a defined benefit plan to contemplate these key issues.
1. Know what you have before you start offering a piece in your Texas divorce
To reasonably divide a pension benefit, like any property, you have to know what it is and its value. Most defined benefit plans produce calculations of benefits at an expected retirement age, such as 65 or 62. For a pre-retirement division, the parties need to know not just the value down the road or even now. They must identify the marital portion of the benefit so the plan administrator can divide it.
When a plan administrator divides a pension it calculates the marital portion and make the division based upon the QDRO. Defined benefit plans generally do not accept QDROs for flat dollar amounts. Similarly, for post-retirement divisions the parties need to know what portion of the annuity payments ties to the employee’s service during the marriage.
Some plan administrators will provide these specific calculations when requested for a divorce. That is more likely if the pension is large and the employer contracted a financial institution to provide recordkeeping services. If the plan administrator cannot or will not provide this calculation then you may need to take what you can get and have an actuary produce the calculation for you.
Defined contribution plans generally do not require these complication calculations. It is still important to obtain statements for the value of the account for the dates of marriage into the date of separation or divorce.
2. Understand the plan payment options from the pension plan
Defined benefit pension benefits can only be paid out in the format and time period defined by the plan. Although many plans now offer a lump sum payment at any time, there are still many plans that do not offer lump sum payments and limit how early a plan benefit can pay out, even to an alternate payee. Many government plans are restrictive in this regard. Knowing how benefits can be paid and when benefits can be paid can be extremely relevant to a division.
For example, an alternate payee who has an urgent need for money will not have her needs met by taking a share of a retirement benefit that can only be paid as a periodic payment. Similarly, an alternate payee with chronic health problems may have a greater risk of premature death and a life annuity may be less valuable than other assets. Defined benefit plans frequently require the participant to separate from employment before even the alternate payee can receive a share of the benefit which can in turn put the alternate payee at the mercy of the participant.
3. Be aware of other QDROs from prior Texas divorces and non-Texas divorces
If the participant has been married prior to the current marriage then it is possible that the prior divorce resulted in a QDRO on the benefit. While this may not affect the dollar figure of the portion of the benefit accrued during the marriage, the prior QDRO may have superior rights to certain plan features attached to the participant’s benefit. This is a huge problem for assigning survivor benefits to the subsequent alternate payee.
If the first alternate payee has obtained survivor benefits through the first QDRO then a later alternate payee cannot obtain those survivor benefits unless the first QDRO is invalidated or the terms of the earlier QDRO result in a reversion of survivor benefits to the participant. I have seen far too many QDROs drafted where an alternate payee has a divorce decree and QDRO in hand awarding that person survivor benefits only to discover an earlier QDRO had already secured the survivor benefits. What happened to the latter alternate payee? SOL.
4. Look out for loans against 401k plans
Most 401k plans permit participants to take loans against their vested benefit. The majority of plans only allow loans when the participant is an active employee with the 401k sponsor. A few plans allow employees to take out loans even after their employment ends. For most plans when an employee ends employment with the 401k sponsor the loan will default after a set period of time. Again there are a few plans that allow periodic payments after employment ends.
An outstanding 401k loan can affect the value of the vested benefit used in calculating the division of a vested benefit under a QDRO. The decision should be made ahead of time whether loans are included or excluded from the value of the vested benefit for segregation purposes and the QDRO should clearly identify this decision. The decision to include the loan balance will depend upon a number of factors, such as why the 401k loan was requested and who is drafting the QDRO.
5. Plan fees for QDRO processing
The vast majority of defined contribution plans charge the participant and/or alternate payee fees for processing QDROs. These fees can range from as little as a few hundred dollars to thousands of dollars. Most plans will divide these fees evenly between the participant and alternate payee but the QDRO can specify who pays the fees. For plans that assess thousands of dollars to the parties, a handful of words designating the payment of processing fees in the QDRO can be worth a lot of money. These plan fees should be considered not only for how the fees are divided but whether the costs of segregating the plan benefit under a QDRO makes dividing the plan benefit an attractive option for on or both parties.
Fortunately, for now, defined benefit plans are not permitted to assess QDRO processing fees against either party.
6. Secret benefits in the 401k or pension
Some defined benefit plans possess hidden benefits and potential benefit increases that can be assigned or divided by a QDRO. They may not truly be secret or hidden benefits but they can be tough to identify if you don’t know what to look for. Finding them often requires looking through the summary plan description and/or plan document to find them. These obscure benefits may come in the way of a pre-retirement death benefit separate from the accrued benefit in the plan, cost of living adjustments and early retirement enhancements. These benefits can sometimes be worth tens of thousands of dollars and just like the plan fees a few words in the QDRO can be worth a lot of money. If these benefits are not properly addressed in the QDRO then they will not be divided and the participant will be the exclusive recipient.
7. Don’t forget the tax man
Retirement benefits held in qualified plans like 401ks and most defined benefit plans are pre-tax funds (or a mix of pre-tax, after-tax and Roth funds). When the plan distributes money it becomes a taxable event for the recipient. (Aside from some very particular tax liability shifting when using QDROs for child support). Most distributions under age 59 1/2 requires payment of ordinary income tax plus a 10% early withdrawal penalty. A distribution to an alternate payee waives the 10% penalty if the distribution goes directly to the alternate payee. (If the alternate payee rolls the QDRO-segregated funds to another tax-advantaged retirement account then that waiver goes away.)
Even when the penalty is waived, the alternate payee may have a sizable tax bill for the distribution. The gross amount of the distribution adds to the alternate payee’s income for the year. As a result the alternate payee may end up paying a much higher tax rate than expected. An alternate payee who sees the retirement funds as a financial life raft may find it has a big hole. Like most divorce attorneys I do not offer tax advice and I would not encourage any attorney without competency in tax law to offer advice. However, a potential alternate payee must understand the risk of a major tax liability. If an alternate payee plans to take a significant distribution in the near future then it is always important to encourage the alternate payee to talk to both a tax adviser and certified financial planner.
8. Addition by subtraction
I’ve seen a lot of domestic relations orders that failed qualification by the plan administrator. A surefire way to fail qualification is including needless language that invites ambiguity in the administrator’s interpretation of the order. There is no reason to provide information about the parties beyond the minimum required to identify the parties. The administrator does not need examples of how you think the formula described in the order works. Do not include provisions requiring the administrator to determine investments for the alternate payee. Do not waste space explaining to the plan administrator what the plan is. The plan administrator knows more about the plan than you do. A QDRO does not need to match the divorce decree in length. ERISA and its volume of regulations already provide a number of protections for the alternate payee.
Some orders fail qualification because they include provisions that oppose plan terms or attempt to create plan provisions that do not exist. A QDRO cannot create new rights for an alternate payee that do not already exist for plan beneficiaries. I’ve seen DROs attempt to create contingent beneficiary schemes that differ from plan rules, attempt to create new distribution options, require notices from the plan administrator where no duty to give notice exists, demand investment in financial instruments not included in the plan and other unusual provisions. Any DRO provision that does not comply with plan rules is sure to result in rejection.
9. Understand why you are dividing this complicated asset in the divorce
Retirement benefits are often one of the largest assets in a divorce. It is no surprise that they go on the table for division in a divorce. However, that alone does not necessarily mean the parties must divide retirement benefits. They are not just piles of money waiting for division; they come along with tax issues, distribution limitations and sometimes even life expectancy concerns. Retirement benefits should be divided when it makes sense to accomplish a fair division of assets. A value analysis is often more important than merely balancing the dollar figure on both sides of the divorce. The value of dividing retirement benefits with a QDRO can change due to factors beyond the plan assets.
The tax status of the retirement funds is a huge issue in valuing a division of retirement assets. For an alternate payee who wants to retain funds as retirement assets the tax-advantaged status is desirable. An alternate payee who needs money for living expenses obtains far less value dollar for dollar after paying taxes. It may be worthwhile to assert a division based upon tax equivalency rather than flat dollar amounts.
Taxes are not the only source of value analysis that can or should be made. Other factors may play a role. For example, investment opportunities, the financial usefulness of retirement assets over other assets, whether dividing retirement assets produces the simplest asset division, whether the alternate payee’s investment sophistication will improve or impair the growth of retirement accounts, the financial stability of the plan sponsor, whether a plan loan is available and a superior division opportunity.
10. Don’t give up on your QDRO
QDROs can sometimes be messy, frustrating problems in a divorce. Some plan administrators are better about properly interpreting QDROs. Some are better than others at promptly and accurately performing the division. Patience and cooperation with plan administrators is often necessary to do what is in a divorce party’s best interests. Many plan administrators understand their plans well but do not understand their responsibilities to a QDRO. Often plan administrators are not well-versed in QDROs and want as little to do as possible with them. They may feel threatened dealing with attorneys and worry about spending too much money to deal with a QDRO.
You may need some hand-holding and in rare cases get aggressive with the plan administrator to appropriately resolve problems. Judicial remedies are available but often the cost-benefit analysis rarely makes these remedies favorable. A firm but cooperative approach often works best with plan administrators.