# Evaluating pension benefits in divorce.

Once CPAs have become familiar with pension valuation and developed referral sources, they will be able to offer a service for which there's growing demand.

CPAs generally have overlooked the consulting opportunity available in evaluating pension benefits in marital dissolutions. Millions of American workers participate in retirement plans - and a large percentage of marriages end in divorce. When a marriage is ending, the future benefits of an employee's retirement plan often are a hotly contested item.

CPAs have let economists and actuaries take the lead in this lucrative business, although accountants are particularly well suited for it because they have the proper training, knowledge and problem-solving ability. CPAs' educational background in present value analysis, finance and law, as well as their training in examining complex issues, constitute the needed foundation on which to build an expertise in the area of pension valuations.

The Pension Benefit Guaranty Corporation (PBGC) developed a set of actuarial and mortality tables that are being used in pension plan valuation in divorce cases. Also, there are excellent sources of published information available to illustrate the evaluation process.

PENSION BENEFIT GUARANTY

CORPORATION

The PBGC was established under provisions of the Employee Retirement Income Security Act of 1974 (ERISA) to provide pension benefits in plan terminations. Its purpose was to ensure that workers earning retirement credit would not lose their benefits if a company went bankrupt or if the plan terminated for other reasons.

The PBGC's actuarial factors used to value the benefits of terminated plans were published in the Prospective Actuarial and Mortality Tables. In recent years, these tables have been used more and more in the valuation of pension plans in divorce cases.

Prospective Actuarial and Mortality Tables contains a set of 21 actuarial tables for immediate annuities at interest rates ranging from 6% to 11%, as well as the mortality tables on which the actuarial tables are based. The current interest rate used can be obtained by telephone or by getting on a monthly mailing list from the PBGC. (The address for relevant information is PBGC, communications and public affairs department, 2020 K Street, N.W., Washington, D.C. 20006-1806. The current immediate PBGC annuity interest rate can be obtained by calling [202] 778-8899.)

PENSION VALUATION IN MARITAL

DISSOLUTION

Evaluating the cash flows of future pension benefits involves determining the cash flows' actuarial present value. This means discounting for interest, for mortality and, when applicable, for vesting. As will be seen, the task can be simplified by using the PBGC tables.

For example, John Brown and his wife are in the process of dissolving their marriage. Mr. Brown participates in a retirement plan at work. Determining the value of his retirement benefits is an important part of the divorce deliberations. Exhibit 1 on page 64 shows important dates and information for Mr. Brown.

Pension specifics. Mr. Brown is a healthy male who is fully vested in a defined benefit plan. In a defined benefit plan, retirement payments are determined by a formula based on factors such as years of service under the plan, the participant's average salary before retirement (for example, that of the last three years) and the participant's age at retirement. In almost all cases, the value of a defined benefit plan is more difficult to calculate than the value of a defined contribution plan. In a typical defined contribution plan - such as a profit-sharing plan - value usually is determined by the individual's balance in his or her account at a specific date.

In this example, pension benefits for Mr. Brown's plan are determined by multiplying each year of service by 0.02 (or 2%). This value is multiplied by the average of the last three years of the employee's compensation, which is $60,000.

For Mr. Brown, the earliest date for normal retirement is 62 years of age. However, many plans provide for early retirement along with a corresponding reduction in benefits.

Basic calculations. Benefits as a percentage of average last three years' compensation = 34.0849 years of service x 0.02 (or 2%) = 0.681698, or 68.1698%

Average compensation for 3 years before valuation = $60,000.

Retirement benefits at valuation date $60,000 x 68.1698% = $40,901.88.

Coverture ratio (the proportion of benefits attained during the marriage) = 19.0795 years of marriage / 34.0849 years of employment = 0.5598

Benefits subject to coverture (benefits x coverture ratio) = $40,901.88 x 0.5598 = $22,896.87 per year or $1,908.07 per month.

SHORT FORMULA METHOD:

PRESENT VALUE OF BENEFITS

Table 4A in the Prospective Actuarial and Mortality Tables presents the PBGC actuarial value of $1 per year deferred to ages 55 through 70 and payable in equal monthly amounts for life thereafter for healthy males and females. PBGC used 6.5% as the interest rate for valuing immediate annuities in May 1992, a rate that corresponds with set C in the tables. (The 21 sets are lettered A through U and are based on increasing interest rates in increments of one-quarter of 1%.) An excerpt from this table is shown in exhibit 2 on page 65.

In this illustration, Mr. Brown will be 48.0932 years of age at the valuation date, so the actuarial values in set C must be interpolated because there is a different value for ages 48 and 49. The difference between the two values (0.2064) is multiplied by the decimal representing the fraction of the year 0.0932) between ages 48 and 49 to arrive at 0.0192. This is added to the table's actuarial value for age 48, 4.0989. Accordingly, the actuarial value of $1 per year deferred to age 62 and payable for life thereafter for a male 48.0932 years old is 4.1181.

Therefore, the present value of the benefits involved in this dissolution is: $1,908.07 x 12 months x 4.1181 = $94,291.48.

LONG FORMULA METHOD

The long formula is a more tedious process but it is useful to know because it contains all the steps in the calculations. In addition to selecting the annuity factor (the present value of $1 per year payable monthly for the life of the participant age X), the long formula specifically involves discounting for mortality and for interest. These procedures were included as part of the short formula method.

The mortality tables in the PBGC Prospective Actuarial and Mortality Tables (for healthy and disabled persons) can be used to discount for the probability of the individual's surviving between the valuation date and the commencement of the annuity. This is illustrated below.

Also, each set includes discount factors for interest between the valuation date and the date the annuity commences. For set C, the discount factors are 1.0575 for each of the first 7 years that precede the commencement of the annuity, 1.045 for each of the 8 years that precede the first 7 years and 1.04 for each year that precedes the first 15 years.

The first step in calculating the value of Mr. Brown's pension benefits using the long formula is to find the present value of $1 per year payable monthly for the life of the participant age 62. This figure, 9.5048, is taken from table 2A, "PBGC Actuarial Functions for Healthy Males." An excerpt from this table from set C is shown in exhibit 3 at left.

Next, discounting for the probability Mr. Brown will survive from valuation date to retirement date is considered. An excerpt from "Mortality Table I" used by the PBGC is illustrated in exhibit 4 on page 66.

The following ratio is needed to find the appropriate discount factor:

Mortality discount factor = factor at date annuity commences / the factor at the valuation date.

Since Mr. Brown will be 48.0932 years old at the valuation date, interpolation for that age is necessary. The mortality factor for age 48 is 9,414.1648 and for age 49 it is 9,366.1243. The factor at the valuation date, 9,409.6874, is found by multiplying the difference between factors for age 48 and 49 by the decimal representing the fraction of the year over 48 years. In this example, 48.0405 is multiplied by 0.0932. The resulting value, 4.4774, is then subtracted from the factor for age 48.

Since the mortality discount is found by dividing the factor at the date the annuity commences by the factor at the valuation date, the factor at age 62, 8,171.0711, is divided by 9,409.6874, the factor at age 48.0932. Therefore, the mortality discount factor for this example would work out to be equal to 0.86837.

Discounting for interest between the valuation date and the annuity commencement date is straightforward. Using a hand calculator, these calculations are easy, even for calculating discount rates that involve fractions of years. As previously mentioned, the discount rate for the seven years before benefits begin is 1.0575 per year. Therefore, the discount factor for these years is 0.676141.

For the preceding 6.9068 years, the discount rate is 1.045 a year. Therefore, the discount factor for these years is 0.737849. This is shown in exhibit 5 below.

Finally, this formula is used to determine the present value of the benefits involved in the Brown's divorce:

Monthly benefits x 12 months x present value of $1 per year payable monthly for the life of participant x (discounting for mortality) x (discounting for interest) = $1,908.07 x 12 x 9.5048 x 0.86837 x 0.676141 x 0.737849 = $94,281.85

This is approximately equal to the present value that was found using the short formula method.

The valuation of pension benefits can be more complex than it is in the above illustration. For example, Mr. Brown was assumed to be 100% vested, but an adjustment might have to be made if this is not the case. State laws on various aspects of pension valuation also differ. For example, there are different rules on what constitutes the valuation date.

For the most part, taxes usually have been ignored in pension valuation. Marvin Snyder says in The Value of Pensions in Divorce: What It Is and How to Use It, "Even though there is no dispute that pensions are taxable when received, it is too speculative to predict constantly changing tax rates."

SOURCES OF PENSION VALUATION

INFORMATION

There are excellent sources for developing the skills necessary to evaluate the present value of pension benefits. The most comprehensive - dealing with both ERISA and NON-ERISA plans - and the one used to help prepare this illustration is Valuation and Distribution of Marital Property, vol. 3, published by Matthew Bender. This volume illustrates, on a step-by-step basis, the calculations necessary to determine the pension values in increasingly complicated situations. Another excellent source is included in Commerce Clearing House's Family Law Tax Guide.

Other useful sources of pension valuation information include

* "Valuation of Retirement Benefits in Marriage Dissolutions," by Murray Projector, Los Angeles Bar Bulletin, April 1975.

* The Value of Pensions in Divorce: What It Is and How to Use It, by Marvin Snyder, Professional Education Systems, Inc., 1990.

Finally, the determining factors in establishing the basis of valuation in each state depend on statute, case law and sometimes local customs. Murray Projector, in "Actuarial Involvement in Divorce Litigation" (published in the 1983-84 Proceedings of the Conference of Actuaries in Public Practice), reports this information should be available in the family law periodical for the state in which the valuation takes place. Family law periodicals - as well as many of the other sources mentioned above - are available in law school and county law libraries. CPAs can always ask the law librarian for assistance.

GETTING STARTED

Attorneys, particularly those in smaller cities, often need competent evaluation services. When a CPA has a firm grasp of the necessary concepts, statutes and appropriate case law, the first step in launching a practice area in pension valuation in divorce usually is made through word of mouth.

Attorneys who are clients or have professional relationships with the CPA should be informed of CPAs' ability to offer this service. If the attorneys do not represent divorce clients, they at least have colleagues who do. Once CPAs become familiar with pension valuation and develop a network of referral sources, they will be able to offer a service that is in increasing demand.

* CPAs GENERALLY HAVE overlooked the consulting opportunity available in evaluating pension benefits in marital dissolutions. When a marriage is ending, the future benefits of an employee's retirement plan often are a hotly contested item.

* THE PENSION BENEFIT Guaranty Corporation (PBGC) developed a set of actuarial and mortality tables that may be used in pension plan valuation in divorce cases. Also, there are excellent sources of published information available to illustrate the evaluation process.

* EVALUATING THE CASH flows of future pension benefits involves determining the cash flows' actuarial present value, which means discounting for interest, for mortality and, when applicable, for vesting.

* FOR A CPA with a firm grasp of the necessary concepts, statutes and appropriate case law, the first step in entering this market is usually made through word of mouth. Attorneys who are clients or have professional relationships with the CPA should be informed that the practitioner is offering this service.

CPAs generally have overlooked the consulting opportunity available in evaluating pension benefits in marital dissolutions. Millions of American workers participate in retirement plans - and a large percentage of marriages end in divorce. When a marriage is ending, the future benefits of an employee's retirement plan often are a hotly contested item.

CPAs have let economists and actuaries take the lead in this lucrative business, although accountants are particularly well suited for it because they have the proper training, knowledge and problem-solving ability. CPAs' educational background in present value analysis, finance and law, as well as their training in examining complex issues, constitute the needed foundation on which to build an expertise in the area of pension valuations.

The Pension Benefit Guaranty Corporation (PBGC) developed a set of actuarial and mortality tables that are being used in pension plan valuation in divorce cases. Also, there are excellent sources of published information available to illustrate the evaluation process.

PENSION BENEFIT GUARANTY

CORPORATION

The PBGC was established under provisions of the Employee Retirement Income Security Act of 1974 (ERISA) to provide pension benefits in plan terminations. Its purpose was to ensure that workers earning retirement credit would not lose their benefits if a company went bankrupt or if the plan terminated for other reasons.

The PBGC's actuarial factors used to value the benefits of terminated plans were published in the Prospective Actuarial and Mortality Tables. In recent years, these tables have been used more and more in the valuation of pension plans in divorce cases.

Prospective Actuarial and Mortality Tables contains a set of 21 actuarial tables for immediate annuities at interest rates ranging from 6% to 11%, as well as the mortality tables on which the actuarial tables are based. The current interest rate used can be obtained by telephone or by getting on a monthly mailing list from the PBGC. (The address for relevant information is PBGC, communications and public affairs department, 2020 K Street, N.W., Washington, D.C. 20006-1806. The current immediate PBGC annuity interest rate can be obtained by calling [202] 778-8899.)

PENSION VALUATION IN MARITAL

DISSOLUTION

Evaluating the cash flows of future pension benefits involves determining the cash flows' actuarial present value. This means discounting for interest, for mortality and, when applicable, for vesting. As will be seen, the task can be simplified by using the PBGC tables.

For example, John Brown and his wife are in the process of dissolving their marriage. Mr. Brown participates in a retirement plan at work. Determining the value of his retirement benefits is an important part of the divorce deliberations. Exhibit 1 on page 64 shows important dates and information for Mr. Brown.

Pension specifics. Mr. Brown is a healthy male who is fully vested in a defined benefit plan. In a defined benefit plan, retirement payments are determined by a formula based on factors such as years of service under the plan, the participant's average salary before retirement (for example, that of the last three years) and the participant's age at retirement. In almost all cases, the value of a defined benefit plan is more difficult to calculate than the value of a defined contribution plan. In a typical defined contribution plan - such as a profit-sharing plan - value usually is determined by the individual's balance in his or her account at a specific date.

In this example, pension benefits for Mr. Brown's plan are determined by multiplying each year of service by 0.02 (or 2%). This value is multiplied by the average of the last three years of the employee's compensation, which is $60,000.

For Mr. Brown, the earliest date for normal retirement is 62 years of age. However, many plans provide for early retirement along with a corresponding reduction in benefits.

Basic calculations. Benefits as a percentage of average last three years' compensation = 34.0849 years of service x 0.02 (or 2%) = 0.681698, or 68.1698%

Average compensation for 3 years before valuation = $60,000.

Retirement benefits at valuation date $60,000 x 68.1698% = $40,901.88.

Coverture ratio (the proportion of benefits attained during the marriage) = 19.0795 years of marriage / 34.0849 years of employment = 0.5598

Benefits subject to coverture (benefits x coverture ratio) = $40,901.88 x 0.5598 = $22,896.87 per year or $1,908.07 per month.

SHORT FORMULA METHOD:

PRESENT VALUE OF BENEFITS

Table 4A in the Prospective Actuarial and Mortality Tables presents the PBGC actuarial value of $1 per year deferred to ages 55 through 70 and payable in equal monthly amounts for life thereafter for healthy males and females. PBGC used 6.5% as the interest rate for valuing immediate annuities in May 1992, a rate that corresponds with set C in the tables. (The 21 sets are lettered A through U and are based on increasing interest rates in increments of one-quarter of 1%.) An excerpt from this table is shown in exhibit 2 on page 65.

In this illustration, Mr. Brown will be 48.0932 years of age at the valuation date, so the actuarial values in set C must be interpolated because there is a different value for ages 48 and 49. The difference between the two values (0.2064) is multiplied by the decimal representing the fraction of the year 0.0932) between ages 48 and 49 to arrive at 0.0192. This is added to the table's actuarial value for age 48, 4.0989. Accordingly, the actuarial value of $1 per year deferred to age 62 and payable for life thereafter for a male 48.0932 years old is 4.1181.

Therefore, the present value of the benefits involved in this dissolution is: $1,908.07 x 12 months x 4.1181 = $94,291.48.

LONG FORMULA METHOD

The long formula is a more tedious process but it is useful to know because it contains all the steps in the calculations. In addition to selecting the annuity factor (the present value of $1 per year payable monthly for the life of the participant age X), the long formula specifically involves discounting for mortality and for interest. These procedures were included as part of the short formula method.

The mortality tables in the PBGC Prospective Actuarial and Mortality Tables (for healthy and disabled persons) can be used to discount for the probability of the individual's surviving between the valuation date and the commencement of the annuity. This is illustrated below.

Also, each set includes discount factors for interest between the valuation date and the date the annuity commences. For set C, the discount factors are 1.0575 for each of the first 7 years that precede the commencement of the annuity, 1.045 for each of the 8 years that precede the first 7 years and 1.04 for each year that precedes the first 15 years.

The first step in calculating the value of Mr. Brown's pension benefits using the long formula is to find the present value of $1 per year payable monthly for the life of the participant age 62. This figure, 9.5048, is taken from table 2A, "PBGC Actuarial Functions for Healthy Males." An excerpt from this table from set C is shown in exhibit 3 at left.

Next, discounting for the probability Mr. Brown will survive from valuation date to retirement date is considered. An excerpt from "Mortality Table I" used by the PBGC is illustrated in exhibit 4 on page 66.

The following ratio is needed to find the appropriate discount factor:

Mortality discount factor = factor at date annuity commences / the factor at the valuation date.

Since Mr. Brown will be 48.0932 years old at the valuation date, interpolation for that age is necessary. The mortality factor for age 48 is 9,414.1648 and for age 49 it is 9,366.1243. The factor at the valuation date, 9,409.6874, is found by multiplying the difference between factors for age 48 and 49 by the decimal representing the fraction of the year over 48 years. In this example, 48.0405 is multiplied by 0.0932. The resulting value, 4.4774, is then subtracted from the factor for age 48.

Since the mortality discount is found by dividing the factor at the date the annuity commences by the factor at the valuation date, the factor at age 62, 8,171.0711, is divided by 9,409.6874, the factor at age 48.0932. Therefore, the mortality discount factor for this example would work out to be equal to 0.86837.

Discounting for interest between the valuation date and the annuity commencement date is straightforward. Using a hand calculator, these calculations are easy, even for calculating discount rates that involve fractions of years. As previously mentioned, the discount rate for the seven years before benefits begin is 1.0575 per year. Therefore, the discount factor for these years is 0.676141.

For the preceding 6.9068 years, the discount rate is 1.045 a year. Therefore, the discount factor for these years is 0.737849. This is shown in exhibit 5 below.

Finally, this formula is used to determine the present value of the benefits involved in the Brown's divorce:

Monthly benefits x 12 months x present value of $1 per year payable monthly for the life of participant x (discounting for mortality) x (discounting for interest) = $1,908.07 x 12 x 9.5048 x 0.86837 x 0.676141 x 0.737849 = $94,281.85

This is approximately equal to the present value that was found using the short formula method.

The valuation of pension benefits can be more complex than it is in the above illustration. For example, Mr. Brown was assumed to be 100% vested, but an adjustment might have to be made if this is not the case. State laws on various aspects of pension valuation also differ. For example, there are different rules on what constitutes the valuation date.

For the most part, taxes usually have been ignored in pension valuation. Marvin Snyder says in The Value of Pensions in Divorce: What It Is and How to Use It, "Even though there is no dispute that pensions are taxable when received, it is too speculative to predict constantly changing tax rates."

SOURCES OF PENSION VALUATION

INFORMATION

There are excellent sources for developing the skills necessary to evaluate the present value of pension benefits. The most comprehensive - dealing with both ERISA and NON-ERISA plans - and the one used to help prepare this illustration is Valuation and Distribution of Marital Property, vol. 3, published by Matthew Bender. This volume illustrates, on a step-by-step basis, the calculations necessary to determine the pension values in increasingly complicated situations. Another excellent source is included in Commerce Clearing House's Family Law Tax Guide.

Other useful sources of pension valuation information include

* "Valuation of Retirement Benefits in Marriage Dissolutions," by Murray Projector, Los Angeles Bar Bulletin, April 1975.

* The Value of Pensions in Divorce: What It Is and How to Use It, by Marvin Snyder, Professional Education Systems, Inc., 1990.

Finally, the determining factors in establishing the basis of valuation in each state depend on statute, case law and sometimes local customs. Murray Projector, in "Actuarial Involvement in Divorce Litigation" (published in the 1983-84 Proceedings of the Conference of Actuaries in Public Practice), reports this information should be available in the family law periodical for the state in which the valuation takes place. Family law periodicals - as well as many of the other sources mentioned above - are available in law school and county law libraries. CPAs can always ask the law librarian for assistance.

GETTING STARTED

Attorneys, particularly those in smaller cities, often need competent evaluation services. When a CPA has a firm grasp of the necessary concepts, statutes and appropriate case law, the first step in launching a practice area in pension valuation in divorce usually is made through word of mouth.

Attorneys who are clients or have professional relationships with the CPA should be informed of CPAs' ability to offer this service. If the attorneys do not represent divorce clients, they at least have colleagues who do. Once CPAs become familiar with pension valuation and develop a network of referral sources, they will be able to offer a service that is in increasing demand.

* CPAs GENERALLY HAVE overlooked the consulting opportunity available in evaluating pension benefits in marital dissolutions. When a marriage is ending, the future benefits of an employee's retirement plan often are a hotly contested item.

* THE PENSION BENEFIT Guaranty Corporation (PBGC) developed a set of actuarial and mortality tables that may be used in pension plan valuation in divorce cases. Also, there are excellent sources of published information available to illustrate the evaluation process.

* EVALUATING THE CASH flows of future pension benefits involves determining the cash flows' actuarial present value, which means discounting for interest, for mortality and, when applicable, for vesting.

* FOR A CPA with a firm grasp of the necessary concepts, statutes and appropriate case law, the first step in entering this market is usually made through word of mouth. Attorneys who are clients or have professional relationships with the CPA should be informed that the practitioner is offering this service.

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Author: | Pope, Ralph A. |
---|---|

Publication: | Journal of Accountancy |

Date: | Aug 1, 1993 |

Words: | 2221 |

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