QDRO or Buyout: Preparing Today for A Secure Tomorrow

One of the most complex and difficult decisions a divorcing couple faces is the division of the pension rights accumulated during the marriage. Some 84 million Americans work for companies that maintain ERISA-covered retirement plans that are divisible by Qualified Domestic Relations Orders (QDROs), which guarantee the non-worker spouse (the non-owner) a share of the pension. Or the couple can opt for a buyout (sometimes called an immediate offset), by which one spouse trades away pension rights for another asset.

Often, both parties have their own pensions, and each may be entitled to share the marital portion of such pension. Generally, however, the husband's benefits are larger than those of the wife, who may have no pension at all or much smaller benefits because of years out of the work force.

The two most valuable assets a divorcing couple divide are the marital home and pension assets, but it is not uncommon for a thrifty couple who lived in a modest home for a long time to discover that the husband's pension may be worth more than the marital home.

The non-worker spouse (we will assume the wife) may be tempted to opt for a buyout far more readily than a QDRO. The woman, faced with near-term problems like keeping a roof over her children's heads and food on the table, fails to consider the long-term problem of retirement income. This option may shortchange her, particularly if her marital contributions have been child rearing and homemaking, because it means that she will head into her so-called “golden years” without any retirement income other than Spousal Social Security.

Very often, divorcing couples, particularly those who divorce pro se , may settle on a buyout of the husband's pension interest without a pension professional placing a value on the plan. Moreover, legal fees may seem off-putting, particularly when the value of the pension seems low. But, because of the high stakes involved, the decision to draft a QDRO ' which gives the non-owning spouse income later in life ' or opt for a buyout ' which provides money up front ' demands good legal advice and the services of a professional pension appraiser.

Financial practice lawyers are familiar with the differences between the defined contribution plan, such as a 401(k), and the traditional defined benefit plan, the old-fashioned company pension. But now, attorneys drafting QDROs must contend with a new type of retirement plan called a “cash balance pension plan” ' a hybrid that is not really the fish of a traditional defined benefit plan, or the fowl of a defined contribution plan.

Cash Balance Plan

A cash balance plan features elements common to both the defined benefit plan and the defined contribution plan. Though technically a defined benefit plan, its individual accounts, which sometimes permit lump-sum distributions upon termination, make the cash balance plan resemble a defined contribution plan. When companies began converting traditional defined benefit plans to cash balance plans, older workers protested that the new routine discriminated against those who were near retirement. Moreover, what was termed a “whipsaw” resulted in the calculation of a participant's account value when different rates ' one for compounding and one for discounting ' were applied.

In a cash balance plan, Joe the Worker at XYZ Corp. receives “defined” pension credits that are a predetermined percent of his annual salary, for example, 6%. In addition, Joe receives “interest credits,” which are based on the annual investment earnings, for example, 5%. But if in investing Joe's account, XYZ's cash balance plan receives a 12% return, for example, the 7% difference goes to the plan, not to Joe's account. Unlike returns earned in a 401(k), which can have real losses and gains in the market, the interest credits, like the pension credits, of a cash balance plan are preordained and set, and Joe has no say in investments in his account.

Many large, older established companies began converting traditional defined benefit plans to cash balance plans several years ago when they began to buckle under the weight of what were termed “legacy costs” that made the traditional company pension plans so expensive. Under the old regime, a worker's pension is based on his or her final average earnings, when he or she is at his peak earning, and on his total years of service. Thus, a worker who retires at 65 with 40 years of service receives a pension based on his average salary times his 40 years of service. By comparison, under a cash balance plan, the worker receives an annual pension credit for each year's actual salary. For example, if Joe the Worker is covered by a traditional defined benefit pension plan, his accrued pension benefit is not based on a percentage of his early years when his wages are low, but based on his annual compensation later in his career when his wages are much higher.

Lawyers dividing pensions must understand the difference between the traditional defined benefit plan and the cash balance plan because the type of QDRO that is appropriate will be different (as may be the entire marital property division strategy). Most attorneys representing Joe the Worker, the participant, lean toward a deferred distribution of the cash balance plan; those representing Joe's wife, the nonparticipant, push for a cashing out with other offsetting assets.

The difficulties in dividing a cash balance pension plan may be complicated even more by the fact that many, if not most, of these plans started as traditional defined benefit pension plans. This means that the plan was converted to a cash balance regime and that, as part of the conversion, the accrued monthly benefit ' the amount that would be payable to Joe the Walker on a monthly basis for the rest of his life beginning when he reaches age 65 ' must be calculated. However, since the cash balance plans (like the 401(k), contain the individual accounts of all the Joe the Workers covered by the plan rather than the accrued monthly benefit amounts, XYZ Corp. must convert Joe's monthly payment to a lump sum amount. The lump sum amount of conversions has been contested in at least three federal court cases, because litigants have contended that “the participant's stated account balance was not judged to be the actual value of the plan.” Hence, the “hypothetical” quality of the account in a cash balance plan.

To deal with this, a lawyer must determine when the company established the cash balance plan and whether it was converted from a traditional defined benefit plan. Then, he can draft a QDRO using one of four basic models. They are as follows:

1. Percent of Total Account Balance as of the Date of Divorce: Provides the alternate payee with a specified percent of the total account balance at the time of the divorce. Ideal for a party who was not married when he enrolled under a traditional defined benefit plan.

2. Coverture Before Conversion and Percent of Account Balance After Conversion: Works if Joe the Worker was covered under a defined benefit plan before it was converted and married before the conversion.

3. “Frozen” Coverture as of the Date of Divorce: Applies a coverture-based formula to the participant's total account as the date of divorce.

4. “Full” Coverture as of Date of Retirement: Works if Joe the Worker was close to his retirement when his plan was converted to a cash balance and a majority of his benefits will be earned under the traditional defined benefit plan.

Post-Marital Enhancements

Sometimes when couples defer the distribution of retirement benefits, disputes arise later because the non-employee spouse contends that she should receive a share of subsequent increases. A well-crafted QDRO insures and protects the parties' rights both pre- and post-retirement, including a Qualified Preretirement Survivor Annuity and a joint and survivor annuity.

While an immediate distribution of pension rights is the preferred route in some jurisdictions because it makes for a clean break between the parties and minimizes court involvement in the future, some courts hold that deferred distribution makes for a more equitable settlement because both spouses can share in future increases if the QDRO provides for them and is drafted that way. “Choosing a deferred distribution via a QDRO instead of offsetting assets may prevent an inequitable result,” wrote an Ohio court in one case.

The downsizing of many large corporations through voluntary and involuntary early retirements has created particular considerations for divorce courts. Millions of American workers have been squeezed out the work force early. Many long-time employees retire voluntarily but not by their own choice, or they retire involuntarily. Retirements under these circumstances may obscure an easy distinction between types of severance pay and early involuntary retirement benefits, particularly when a person retires early after a divorce. Sometimes, early retirement benefits can be seen as compensation to an employee for a specific service, that is, retiring early. Courts face the challenge of deciding what portion of these benefits is separation pay (and separate property) and what portion are retirement benefits earned during a marriage (and marital property).

Courts are divided about the sharing of post-divorce pension increases (e.g., early retirement subsidies and benefit enhancements), particularly for deferred distribution pensions. Predictably, when a dispute arises, the employee spouse (often the man) argues that the increase happened after the marriage, and the sharing spouse (often the women) asserts that the increase happened as a result of years of employment during the marriage.

Courts have taken different positions about the sharing of post divorce separation pay. Generally, separation pay after a divorce as a result of involuntary retirement is viewed as separate property because it is seen as compensation for lost future earnings. Overall, courts may look at early retirement benefits as compensation for past service if the employee is at a high point in his or her productivity rather than a low one.

Voluntary early retirement by the pension-owning spouse creates the risk that he or she may retire for the bad-faith reasons for a larger share of the retirement pie.

In recent years, some workers, particularly those in state and local government, have elected to participate in DROP (Deferred Retirement Option Program) retirement programs. Under DROP, the worker no longer accrues service, and he is treated as if he retired while continuing to work. Benefits he has earned are paid into an account in his name, which is paid interest and any cost of living increases he would have received if he had been retired. DROP permits an employee to postpone collection of benefits he has earned, and they are classified, in the event of a divorce, in the same way they would have been classified if the DROP route had not been taken.

Conclusion

For obvious reasons, both parties and their lawyers must clearly consider pension benefits. Tempting as it may be to take a buyout, a woman ' particularly one going into the golden years on her own ' should make certain she understands what she is giving up.

Theodore K. Long, Jr. is the president of Pension Appraisers, Inc. which operates QdroDesk.com and PensionAppraisalDesk.com.

One of the most complex and difficult decisions a divorcing couple faces is the division of the pension rights accumulated during the marriage. Some 84 million Americans work for companies that maintain ERISA-covered retirement plans that are divisible by Qualified Domestic Relations Orders (QDROs), which guarantee the non-worker spouse (the non-owner) a share of the pension. Or the couple can opt for a buyout (sometimes called an immediate offset), by which one spouse trades away pension rights for another asset.

Often, both parties have their own pensions, and each may be entitled to share the marital portion of such pension. Generally, however, the husband's benefits are larger than those of the wife, who may have no pension at all or much smaller benefits because of years out of the work force.

The two most valuable assets a divorcing couple divide are the marital home and pension assets, but it is not uncommon for a thrifty couple who lived in a modest home for a long time to discover that the husband's pension may be worth more than the marital home.

The non-worker spouse (we will assume the wife) may be tempted to opt for a buyout far more readily than a QDRO. The woman, faced with near-term problems like keeping a roof over her children's heads and food on the table, fails to consider the long-term problem of retirement income. This option may shortchange her, particularly if her marital contributions have been child rearing and homemaking, because it means that she will head into her so-called “golden years” without any retirement income other than Spousal Social Security.

Very often, divorcing couples, particularly those who divorce pro se , may settle on a buyout of the husband's pension interest without a pension professional placing a value on the plan. Moreover, legal fees may seem off-putting, particularly when the value of the pension seems low. But, because of the high stakes involved, the decision to draft a QDRO ' which gives the non-owning spouse income later in life ' or opt for a buyout ' which provides money up front ' demands good legal advice and the services of a professional pension appraiser.

Financial practice lawyers are familiar with the differences between the defined contribution plan, such as a 401(k), and the traditional defined benefit plan, the old-fashioned company pension. But now, attorneys drafting QDROs must contend with a new type of retirement plan called a “cash balance pension plan” ' a hybrid that is not really the fish of a traditional defined benefit plan, or the fowl of a defined contribution plan.

Cash Balance Plan

A cash balance plan features elements common to both the defined benefit plan and the defined contribution plan. Though technically a defined benefit plan, its individual accounts, which sometimes permit lump-sum distributions upon termination, make the cash balance plan resemble a defined contribution plan. When companies began converting traditional defined benefit plans to cash balance plans, older workers protested that the new routine discriminated against those who were near retirement. Moreover, what was termed a “whipsaw” resulted in the calculation of a participant's account value when different rates ' one for compounding and one for discounting ' were applied.

In a cash balance plan, Joe the Worker at XYZ Corp. receives “defined” pension credits that are a predetermined percent of his annual salary, for example, 6%. In addition, Joe receives “interest credits,” which are based on the annual investment earnings, for example, 5%. But if in investing Joe's account, XYZ's cash balance plan receives a 12% return, for example, the 7% difference goes to the plan, not to Joe's account. Unlike returns earned in a 401(k), which can have real losses and gains in the market, the interest credits, like the pension credits, of a cash balance plan are preordained and set, and Joe has no say in investments in his account.

Many large, older established companies began converting traditional defined benefit plans to cash balance plans several years ago when they began to buckle under the weight of what were termed “legacy costs” that made the traditional company pension plans so expensive. Under the old regime, a worker's pension is based on his or her final average earnings, when he or she is at his peak earning, and on his total years of service. Thus, a worker who retires at 65 with 40 years of service receives a pension based on his average salary times his 40 years of service. By comparison, under a cash balance plan, the worker receives an annual pension credit for each year's actual salary. For example, if Joe the Worker is covered by a traditional defined benefit pension plan, his accrued pension benefit is not based on a percentage of his early years when his wages are low, but based on his annual compensation later in his career when his wages are much higher.

Lawyers dividing pensions must understand the difference between the traditional defined benefit plan and the cash balance plan because the type of QDRO that is appropriate will be different (as may be the entire marital property division strategy). Most attorneys representing Joe the Worker, the participant, lean toward a deferred distribution of the cash balance plan; those representing Joe's wife, the nonparticipant, push for a cashing out with other offsetting assets.

The difficulties in dividing a cash balance pension plan may be complicated even more by the fact that many, if not most, of these plans started as traditional defined benefit pension plans. This means that the plan was converted to a cash balance regime and that, as part of the conversion, the accrued monthly benefit ' the amount that would be payable to Joe the Walker on a monthly basis for the rest of his life beginning when he reaches age 65 ' must be calculated. However, since the cash balance plans (like the 401(k), contain the individual accounts of all the Joe the Workers covered by the plan rather than the accrued monthly benefit amounts, XYZ Corp. must convert Joe's monthly payment to a lump sum amount. The lump sum amount of conversions has been contested in at least three federal court cases, because litigants have contended that “the participant's stated account balance was not judged to be the actual value of the plan.” Hence, the “hypothetical” quality of the account in a cash balance plan.

To deal with this, a lawyer must determine when the company established the cash balance plan and whether it was converted from a traditional defined benefit plan. Then, he can draft a QDRO using one of four basic models. They are as follows:

1. Percent of Total Account Balance as of the Date of Divorce: Provides the alternate payee with a specified percent of the total account balance at the time of the divorce. Ideal for a party who was not married when he enrolled under a traditional defined benefit plan.

2. Coverture Before Conversion and Percent of Account Balance After Conversion: Works if Joe the Worker was covered under a defined benefit plan before it was converted and married before the conversion.

3. “Frozen” Coverture as of the Date of Divorce: Applies a coverture-based formula to the participant's total account as the date of divorce.

4. “Full” Coverture as of Date of Retirement: Works if Joe the Worker was close to his retirement when his plan was converted to a cash balance and a majority of his benefits will be earned under the traditional defined benefit plan.

Post-Marital Enhancements

Sometimes when couples defer the distribution of retirement benefits, disputes arise later because the non-employee spouse contends that she should receive a share of subsequent increases. A well-crafted QDRO insures and protects the parties' rights both pre- and post-retirement, including a Qualified Preretirement Survivor Annuity and a joint and survivor annuity.

While an immediate distribution of pension rights is the preferred route in some jurisdictions because it makes for a clean break between the parties and minimizes court involvement in the future, some courts hold that deferred distribution makes for a more equitable settlement because both spouses can share in future increases if the QDRO provides for them and is drafted that way. “Choosing a deferred distribution via a QDRO instead of offsetting assets may prevent an inequitable result,” wrote an Ohio court in one case.

The downsizing of many large corporations through voluntary and involuntary early retirements has created particular considerations for divorce courts. Millions of American workers have been squeezed out the work force early. Many long-time employees retire voluntarily but not by their own choice, or they retire involuntarily. Retirements under these circumstances may obscure an easy distinction between types of severance pay and early involuntary retirement benefits, particularly when a person retires early after a divorce. Sometimes, early retirement benefits can be seen as compensation to an employee for a specific service, that is, retiring early. Courts face the challenge of deciding what portion of these benefits is separation pay (and separate property) and what portion are retirement benefits earned during a marriage (and marital property).

Courts are divided about the sharing of post-divorce pension increases (e.g., early retirement subsidies and benefit enhancements), particularly for deferred distribution pensions. Predictably, when a dispute arises, the employee spouse (often the man) argues that the increase happened after the marriage, and the sharing spouse (often the women) asserts that the increase happened as a result of years of employment during the marriage.

Courts have taken different positions about the sharing of post divorce separation pay. Generally, separation pay after a divorce as a result of involuntary retirement is viewed as separate property because it is seen as compensation for lost future earnings. Overall, courts may look at early retirement benefits as compensation for past service if the employee is at a high point in his or her productivity rather than a low one.

Voluntary early retirement by the pension-owning spouse creates the risk that he or she may retire for the bad-faith reasons for a larger share of the retirement pie.

In recent years, some workers, particularly those in state and local government, have elected to participate in DROP (Deferred Retirement Option Program) retirement programs. Under DROP, the worker no longer accrues service, and he is treated as if he retired while continuing to work. Benefits he has earned are paid into an account in his name, which is paid interest and any cost of living increases he would have received if he had been retired. DROP permits an employee to postpone collection of benefits he has earned, and they are classified, in the event of a divorce, in the same way they would have been classified if the DROP route had not been taken.

Conclusion

For obvious reasons, both parties and their lawyers must clearly consider pension benefits. Tempting as it may be to take a buyout, a woman ' particularly one going into the golden years on her own ' should make certain she understands what she is giving up.

Theodore K. Long, Jr. is the president of Pension Appraisers, Inc. which operates QdroDesk.com and PensionAppraisalDesk.com.