Disability Pensions

Employers typically provide two types of disability coverage: disability pensions through their ERISA governed qualified retirement plan, and coverage through their stand alone short and long term disability programs. Under most circumstances, the benefits received under the short and long term disability programs represent replacement income and are not subject to equitable distribution.

A gray area arises as to whether disability pensions under defined benefit pension plans should be subject to equitable distribution. Plan participants argue that the payments represent income replacement, similar to the short and long term disability programs. Nonparticipants counter that because the retirement pension has commenced (albeit in the form of a disability pension), it should be subject to equitable distribution. Both sides have valid points.
Nonparticipants are correct in asserting that, in many cases, disability pensions represent a type of early commencement feature under the pension plan, allowing the participant to commence his or her unreduced accrued benefit immediately. Their conclusion that this early commencement feature transforms the entire disability pension into a retirement pension is not entirely accurate. Accelerating the retirement age of the plan participant significantly increases the plan's funding costs and the resulting present value of a pension. To assert that the windfall increase in value should accrue to the marital estate is questionable.

Also questionable is the characterization of the entire disability pension as income replacement. If the disability pension is intended as a lifetime annuity, it will replace or incorporate the participant's regular accrued benefit under the pension plan. As such, disability pensions often incorporate the same formula components as other types of retirement, such as early or normal retirement. For example, a participant's years of service and average compensation may be elements used in computing the disability pension.
Always compare the disability benefit formula with the plan's regular accrued benefit pension formula to help substantiate a portion of the disability pension as a marital asset. In fact, many plans recharacterize the disability pension as a regular plan pension upon the participant's attainment of the normal retirement age. Keeping in mind the diversity of disability pensions, make a careful analysis of the amount and duration of each disability pension. Some may remain constant for the participant's entire lifetime, but others may change once he or she reaches normal retirement age.

This information will help establish a middle ground in performing present values on disability pensions by establishing the extent to which the pension constitutes a regular pension subject to division at divorce. That component should stand as the marital share of the disability pension and the remainder represents an insurance award or income replacement.

The QDRO issues of disability pensions are more subtle. When representing the plan participant and the disability is not life threatening, the present value approach with offsetting assets should be the preferred distribution method. When representing the nonparticipant, using a QDRO that allows for commencement of benefits when they begin for the participant and calling for a possible recalculation of the coverture percentage when the participant reaches the normal retirement age is typically advantageous.

Disability benefits differ dramatically from company to company. For example, the following issues should be reviewed with respect to the various disability programs:

1. How the disability pension is calculated and whether future service is included in the formula.

2. Whether the disability pension is immediate or deferred.

3. The extent to which the disability pension is in lieu of other plan benefits. This is a key point in demonstrating to the court that the participant's disability pension actually incorporates his or her accrued benefit under the pension plan.

Keep in mind that many disability pensions contain offset provisions subject to various reductions, which may include the company's long term disability program, workers' compensation benefits (including lump sum settlements), and Social Security disability payments.

EQUITABLE DISTRIBUTION

The primary advantage to employees of most disability pensions under a defined benefit pension plan is the immediacy with which employees can commence their pension benefits. This early commencement feature effectively provides employees with subsidized benefits above and beyond the value of their accrued benefit to date. Remember, a participant's accrued benefit as of any point in time is inherently structured to commence on an unreduced basis at his or her normal retirement age. In the case of a disability pension, participants may typically commence their accrued benefit immediately, which significantly increases the present value of their pensions. This difference in value between the disability pension and the basic accrued benefit usually represents the “replacement income” portion of the company sponsored disability benefits.
This issue is being hotly contested throughout the country. From an equity standpoint, it makes little sense for the nonparticipant to collect an insurance type windfall as a result of the participant's injury or illness. It may make more sense to base the nonparticipant's share of any disability pension on the marital portion of the amounts attributable solely to the employee's accrued benefit as of the date of disability. In this manner, the employer subsidized income replacement portion of the disability pension inures solely to the participant. This logic is also consistent with most states' treatment of workers' compensation benefits.
Consider the following example:

Example

Tom is employed at Company ABC. He became totally and permanently disabled on June 1, 1999, at the age of 40. His regular accrued benefit under the plan was $1,000, commencing on an unreduced basis as early as age 62. Under the terms of the plan, he is eligible for an immediate disability pension of $1,000 per month for the remainder of his lifetime. In analyzing the present values of the immediate disability pension and the accrued benefit at age 62, the differences are significant. The immediate disability pension is worth $184,000, but the deferred pension has a value of $34,000. The question is, should the nonparticipant spouse share in the $150,000 windfall to the disabled participant? In other words, assuming the couple were married throughout his entire employment with Company ABC, should she receive $500 per month immediately for the remainder of his lifetime? This does not appear to be reasonable or equitable, considering the cause of the event that triggered the disability pension and the income replacement component of the disability award.

Based on an equitable approach, the nonparticipant should be entitled to commence her share of the benefits immediately as a result of the participant's disability pension; however, her share should be based on 50 percent of the present value of the accrued benefit at age 62. This should represent a payment of approximately $104 per month to the nonparticipant. Remember, her $500 benefit would have typically started at his age 62. Therefore, the $396 reduction in her actual benefit reflects 22 years of discounting to the present time. The QDRO in this case should provide that the alternate payee is to receive $104 per month for the remainder of the employee's lifetime. It is also possible to include survivorship rights for the alternate payee or base her share of the benefits on her own life expectancy; however, if the participant is already in receipt of his disability pension, it is probably too late to instruct the plan administrator to structure the ex wife's payments on her own life expectancy.

GOVERNMENT PLANS

ERISA exempt government plans work quite differently because they offer coverage in lieu of Social Security. For that reason, they often grant an immediate pension that assumes that the participant had continued working until a specific age.

The same logic for valuing ERISA plans holds for ERISA exempt plans. The income replacement component of the disability pension can be assessed by determining how much the disability pension exceeds the participant's accrued benefit at the date of disability. Under this scenario, when projected service is incorporated into the calculation of the disability pension, it may make sense to use a two step process to determine how much of the pension is to be included in the marital estate.

The amount payable to the nonparticipant prior to the plan's normal retirement age should be based on a coverture fraction applied to the participant's accrued benefit as of the date of the disability. The nonparticipant's benefits should be further reduced on an actuarial basis to reflect an early commencement. This amount will continue to be payable to the nonparticipant until the participant's retirement age is reached. At that time, a new coverture fraction that incorporates the years of projected service will be applied to the participant's final lifetime benefit.

Example

The participant retires on a disability pension at age 43. His nonparticipant wife is the same age. His regular accrued benefit, based on his 18 years of actual employment, is $1,000 per month at age 60. His disability pension, which incorporates an additional 17 years of projected service (to age 60), provides him with an immediate payment of $2,000 per month, payable for life. The ex wife's 50 percent share is not based on the actual $2,000 monthly payment because much of the payment is income replacement. Instead, her share is based on 50 percent of his accrued benefit, which would be $500 per month starting when he turns 60. This amount should be further reduced to reflect her early commencement as of the date of his disability. That “actuarially adjusted” payment reflecting the early commencement may be only $147. She will continue to receive this benefit for the rest of his life or until he attains his normal retirement age, at which time his disability pension converts into a normal retirement, nondisability pension.

The ex wife's share of the pension should then be recalculated to determine a new marital portion based on the projected years of service that were incorporated into the pension benefit. In this example, the participant's normal retirement pension of $2,000 per month will be multiplied by a new coverture fraction of 18 (years of marriage) over 35 (years of total service), or 51.4 percent. When the marital portion of 50 percent is factored in, the nonparticipant receives 25.7 percent of the employee's final pension of $2,000, or $514 a month for the remainder of his lifetime.

Increasing the alternate payee's pension amount from $147 to $514 per month represents a change in methodology from receiving a frozen share of the participant's accrued benefit at the time of disability, compared to receiving a coverture percentage of his final accrued benefit under the plan when it has come to fruition. In other words, she is reaping some of the inflationary aspects of his final pension benefit under the standard coverture approach. When her share of the accrued benefit payable during disability is exhausted (at his age 60) and the company recharacterizes his disability pension as a nondisability pension, she simply receives a coverture percentage of his projected pension.

WHY NONPARTICIPANTS SHOULD CHOOSE A QDRO

The preceding example should illustrate that the only possible way for a nonparticipant to share growth in a disability pension may be with a properly drafted QDRO. Disability present values are frequently based solely on the frozen accrued benefit. In our example, many jurisdictions would have awarded only the $1,000 monthly benefit starting at age 60 to the marital estate. The nonparticipant would have received offsetting assets based on the actuarial equivalent of $147 per month for his lifetime. The nonparticipant would not have received a present value equivalent of the additional $367 ($514 – $147) commencing at the employee's age 60. This is another reason for using a QDRO when the participant's health is an issue and you represent the nonparticipant.