OVERVIEW

Whether calculating a present value or drafting a QDRO, determining the portion of the participant's pension benefits earned during the marriage becomes a key issue. This chapter discusses the recommended approach to dividing benefits under a defined benefit pension plan as well as the approaches to avoid. As discussed in great detail, there is generally one approach to follow, the “coverture” approach. In order to understand the advantages and pitfalls of the various methods used today, it is imperative to understand the inner workings of defined benefit plans—from their actuarial funding methodology to the calculation of a participant's accrued benefit under a myriad of plan formulas.
Under a defined benefit pension plan, no interest or investment earnings are incorporated into a participant's benefits. An accrued benefit, which is defined by the plan formula, can be calculated as of any date during the participant's working career. It often incorporates his or her years of service and his or her average salary over a designated period of time (five years is common).

The question of inflationary protection for the nonparticipant frequently arises because he or she often must wait for years to receive his or her share of the participant's benefits. Courts around the country use several approaches that attempt to provide such inflationary protection for the nonparticipant. Some courts simply believe that all postdivorce salary increases are nonmarital, essentially freezing the nonparticipant's share of the pension as of the date of the divorce. This would be tantamount to freezing the nonparticipant's share of a 401(k) plan as of the date of divorce and providing 100 percent of the future interest and investment earnings to the participant.

Although defined benefit and defined contribution plans have inherent structural differences, the inflationary issues remain constant. The basic argument over salary increases hinges on which portion is attributable to inflation versus merit increases. The marital estate should incorporate postdivorce inflationary increases but exclude merit related increases. The standard coverture approach may include some minimal element of merit, but it has been shown that nearly 90 percent of salary increases are solely attributable to inflationary trends.

SUBTRACTION METHOD

Under the subtraction method (also referred to as the present value difference method), the present value of the pension at the time of the marriage is subtracted from the present value at the time of divorce.

At first glance, the logic of the subtraction method is compelling. But after careful review, the flaws become apparent. Using the subtraction method is not only terribly misleading, it also contradicts the fundamental design and actuarial finding principles of defined benefit pension plans.

Subtraction method proponents contend that under a salary based defined benefit plan, the benefits and the associated funding tend to build much more rapidly in the years before retirement, because those are the years of highest earnings. That assertion is misleading. When plan actuaries establish the funding of a salary related pension, they utilize one of several actuarial funding mechanisms in order to project future benefits. [A detailed review of such mechanisms can be found in Gee, 1993.] In other words, they incorporate such assumptions as future interest rates, mortality assumptions, and, more importantly, anticipated salary growth rates. They apply these assumptions either individually or in the aggregate to the future projected benefits of all plan participants and then recommend annual, somewhat level funding costs for the plan based on the present values of such future projected benefits. In this manner, the plan makes its annual contributions to help fund such future benefits.

Defined benefit pension plans are actuarially funded in somewhat equal building blocks. That is, the goal of any sound actuarial funding method when plan benefits are based on final salaries is to provide annual funding standards (that is, annual plan contributions) that do not allow the participants' inevitable salary increases to overwhelm the plan's funding. In simple terms, these annual building blocks are referred to as the plan's normal cost. Although the specific plan's normal cost each year may or may not change, it is intended to provide the plan administrator with a somewhat level and predetermined funding schedule that assures plan solvency by anticipating the future growth of a participant's pension benefits.

A salary chart makes the point far more clearly. Table 18 1 demonstrates that although salaries do increase in later years in response to inflation, the actual annual funding for a pension remains surprisingly constant. It certainly should come as no surprise that actuaries incorporate these anticipated salary increases when they design the plan's annual funding requirements.

It is important to understand that although the actual contributions made to the plan may be smaller in the early years of plan participation, such contributions have a chance to compound over a longer period of time. The power and effects of interest compounding, as the bankers and mutual fund salespeople will tell you, are staggering. Defined benefit plans are designed to be actuarially sound. Therefore, there must be sufficient monies invested on an ongoing basis to provide for future plan liabilities. They are not merely Social Security transfer of payment systems, in which money coming in the back door is paid out at the front door.

Table 18 1 shows a review of a defined benefit plan. Note that although this is an oversimplification of the contribution process, in that it assumes a level percentage rather than a periodic recalculation based on the plan's actual investment experience and changes in employee profiles, it does illustrate several important points.

Although the 1995 salary is slightly more than double the 1983 salary, the employer's contributions for 1995, rather than being worth more, are actually worth somewhat less.

Coverture opponents ignore the time value of money. The larger, more recent contributions are not more valuable than the smaller, older contributions. Older contributions compounding tax free within a qualified plan can frequently be more valuable than more recent contributions. While the funding for defined benefit plans does differ somewhat from year to year based on investment results and plan experience, it is important to employ coverture in dividing pensions for two reasons. First, coverture reflects the roughly equal yearly building blocks that go into funding a plan participant's pension. Second, sound public policy dictates that simple, equitable methods be employed that will not unduly enrich or deprive the plan participant and nonparticipant of their fair share of the pension. To jettison coverture based QDROs would inevitably result in shortchanging the first spouse in a multiple marriage scenario for a plan participant.

Example of Defined Benefit Plan

The subtraction method, as utilized by some, applies no meaningful reasoning (mathematical or otherwise) in dividing pensions under a defined benefit pension plan. Its use is somewhat compelling because it appears to provide an alternate payee with inflationary protection while using “fuzzy logic,” but it has no sound basis in fact or theory. As already shown, a participant's pension benefit is calculated in equal, annual increments, because it applies a specific plan formula to each of his or her years of past service under the plan. The subtraction method determines the alternate payee's share of the participant's pension by subtracting the participant's accrued benefit under the plan (some proponents use the final present value of that accrued benefit) as of his or her date of divorce from his or her accrued benefit (or its equivalent present value thereof) under the plan calculated as of his or her date of marriage to the alternate payee. It sounds simple—too simple, in fact.

Only an H.G. Wells enthusiast cares what the pension was at the time of the marriage. That pension no longer exists. With each subsequent year, the participant's pension grows closer and closer to the funding that has been established for it. The fact that a participant's accrued benefit under a plan 10 years earlier on the date of the marriage was $200 per month, for example, has no current meaning, just as the present value of the accrued benefit, as calculated on that date, would have no meaning today.

During each plan year following the marriage, the accrued benefit (incorporating all of the previous years of service with the company) has been totally recast and any prior calculation becomes null and void. This clearly illustrates the failure of the subtraction method in equitably dividing a participant's pension benefits.

COVERTURE

The country's leading experts in the field of present values and qualified domestic relations orders may refer to their recommended method of dividing pensions under a defined benefit plan by different names, such as the coverture approach, the marital portion approach, the fixed percentage method [Petschel v. Petschel, 406 N.W.2d 604 (Minn. Ct. App. 1987)], and the proportionate share approach [Hoyt v. Hoyt, 53 Ohio St. 3d 177, 559 N.E.2d 1292 (1990)], but they are all based on identical methodology.

This recommended approach, the coverture approach, provides the nonparticipant (alternate payee) with a proportionate share of the participant's accrued benefit under a defined benefit pension plan. Under a defined benefit pension plan, unlike a defined contribution plan such as a 401(k) or profit sharing plan, a participant is promised a future projected retirement benefit (accrued benefit). This benefit, which typically commences on an unreduced basis at the participant's normal retirement age, is calculated in accordance with a plan formula that often incorporates years of service, final average salary, or, if an hourly plan, the benefit level in effect as of the participant's date of retirement. Employers then make regular annual contributions to the plan during their employees' working careers in accordance with actuarial projections of the sums needed to fund such future promised pension benefits.

Because future projected accrued benefits are promised under a defined benefit plan, it is the plan that bears the investment risk if the plan is inadequately funded. For this reason, neither contributions nor interest are typically posted to individual accounts in a defined benefit plan; therefore, the only equitable means of protecting the alternate payee against future inflationary trends during the years prior to the commencement of benefits is to structure the alternate payee's portion of the participant's accrued benefit using the coverture approach. This effectively bases the alternate payee's share of the benefits on the marital portion of the participant's accrued benefit calculated as of his or her date of retirement rather than the date of divorce, when the participant's benefit would, of course, be larger.

The marital portion is determined by multiplying the participant's accrued benefit by a fraction, the numerator of which is the number of months of the participant's service under the plan while married to the alternate payee, and the denominator of which is the participant's total number of months of service under the plan as of the date of cessation of benefit accruals, which is typically the participant's date of retirement.

In calculating the coverture fraction, some attorneys make the mistake of defining the numerator as the duration of the marriage without considering the possibility that the participant was not covered under the plan during the entire marriage. Only the years of service accumulated under the plan while married should be used to define the numerator.

Under the coverture approach, the alternate payee's share of the benefits is still based solely on the participant's years of service while married to the alternate payee. In adopting this approach as the equitable means of dividing pensions under a defined benefit pension plan, the Ohio Supreme Court stated:
@EX = In determining the proportionality of the pension or retirement benefits, the nonemployed spouse, in most instances, is only entitled to share in the actual marital asset. The value of this asset would be determined by computing the ratio of the number of years of employment of the employed spouse during the marriage to the total years of his or her employment. [Hoyt v. Hoyt, at 182]

Under most pension plans, the benefits accrued by the participants are calculated based upon the plan formula in effect on their date of retirement, which typically incorporates their final average salary and a specified plan formula percentage. Once the applicable percentage is applied to the average salary component of the plan, the product is then multiplied by the participant's total years of service under the plan to determine the accrued benefit at retirement; therefore, from a procedural and mathematical standpoint, the benefits actually accrue at equal intervals for each year of service under the plan.

Example 18 1.<_>After working for the ABC Corporation for 30 years, Joan is preparing to retire at age 65 at the end of 1998. She is covered under a salaried defined benefit pension plan. The annual accrued pension is calculated by multiplying her years of service by her highest three year average salary. This product is further multiplied by a 1.8 percent factor to produce the monthly annuity. Joan's pay for the three year period prior to retirement was: $45,000 for 1996, $48,000 for 1997, and $51,500 for 1998. Her final average salary is determined to be $48,166.67 ($45,000 + $48,000 + $51,500 = [$144,500 <F128M>ÿ<F255D> 3]). Joan's annual accrued pension will be $26,010 (30 years of credited service x 1.8% x $48,166.67).

For equitable distribution purposes, the nonparticipant is then typically entitled to 50 percent of the marital portion of the participant's final accrued benefit under the plan. Again, some attorneys forget to apply the 50 percent component to the formula and attempt to provide the nonparticipant with the entire coverture percentage (the entire marital portion of the participant's final accrued benefit). The participant receives 100 percent of the nonmarital benefits and 50 percent of the marital portion of the benefits.

Those who espouse the subtraction method incorrectly believe that the coverture approach attempts artificially to spread the entire benefit accrual over the participant's working career. Nothing could be further from the truth. There are no artificial spreads associated with the way the plan administrator calculates a participant's accrued benefits, which is in accordance with the terms and provisions of the pension plan document. As already stated, when a company calculates a participant's accrued benefit, it applies the identical percentage of final average salary to each year of the participant's service with the company. This is the essence of the defined benefit calculation. The participant is effectively reaping the benefits of the plan formula components in effect on the date of retirement (that is, the final average salary and the formula percentages) for each year of his or her service with the company. The fact that the pay may have grown over the last several years of employment does not alter the fact that the final accrued benefit is made up of equal shares accumulated for each year of service.

The logic for employing coverture applies equally to defined benefit plans that are non salary based. Under an hourly pension plan such as that of the United Auto Workers, the formula for calculating a participant's accrued benefit typically incorporates the participant's years of service with the company (similar to a salaried plan) and a benefit multiplier that is in effect at the date of the employee's retirement. For example, if an hourly employee retired in 1980 with 30 years of service when the benefit multiplier was equal to $15 per month per year of service, the monthly pension benefit equaled $450 per month (30 x $15). In 1999, the typical UAW retiree's benefit would be calculated on a multiplier of approximately $40. A 1993 retiree under the Boilermaker Blacksmith National Pension Trust would have retired with a pension determined by multiplying his or her total contributions by 41 percent. A current retiree would have retired under a benefit multiplier of 46.75 percent.

Hourly pension plans use a benefit multiplier in lieu of final average compensation for a number of reasons. First, an hourly employee does not necessarily receive annual increases in compensation to the same extent as salaried employees, which could yield a lower benefit 30 years later if final average compensation were used in the calculation. Second, because many hourly employees are covered under a collective bargaining agreement between the company and a union, the subject of pension benefits is usually a negotiated item during contract negotiations. If final average pay were used to calculate an hourly employee's future pension benefit, the union would have less control over such benefit; however, if a benefit multiplier is used, the union can attempt to negotiate higher pension benefits for members.

When a present value or a QDRO deals with an hourly plan based on a benefit multiplier, should the postdivorce contractual increases be totally excluded from the marital estate? The authors believe that excluding those increases unfairly enriches the participant and unfairly excludes the nonparticipant from sharing the inflation adjustments provided by labor negotiations.

The equitable approach to utilize in the vast majority of circumstances when dividing pension benefits under a defined benefit pension plan is the coverture approach. This approach recognizes how benefits are calculated under defined benefit pension plans, and then calculates the proportionate share upon which the alternate payee's benefits are based. The beauty of the coverture approach is that it always provides a fair and equitable distribution of benefits under a defined benefit plan, regardless of which party an attorney is representing (participant or nonparticipant).
There is another compelling reason for not using the subtraction method when dividing pension benefits under a defined benefit pension plan. It could be called the “two wives dilemma.” From a practical standpoint, the subtraction method breaks down when coupled with a QDRO that purports to provide the alternate payee with a proportionate share of the participant's accrued benefit calculated as of the date of retirement.

Example 18 2.<_>Husband is employed at Company ABC for 30 years. During his 30 year period of service, he was married to Ex Wife 1 for the first 20 years and to Ex Wife 2 for the next 10 years. Ex Wife 1 has been granted a QDRO that provides her with a proportionate share of his 30 year pension with Company ABC. In other words, the coverture approach was utilized to provide Ex Wife 1 with what effectively amounts to 33.3 percent of the final accrued benefit under the plan (50% x final accrued benefit x 20/30).

The divorce court in Ex Wife 2's case adopts the subtraction method, which provides Ex Wife 2 with 42.5 percent of his pension (under this erroneous method, the court assumed that 85 percent of his pension was accumulated during the last 10 years of his marriage to Ex Wife 2). Now, the two ex wives of the participant will receive in the aggregate 75.8 percent of his pension benefits, and he will be entitled to a mere 24.2 percent.

The use of the subtraction method cannot coexist with the coverture approach in a multiple divorce scenario. This is not the case with the coverture approach. It provides, with few exceptions, for a fair and equitable distribution of pension assets, even in multiple ex spouse settings. Had the coverture approach been utilized in the previous example, Ex Wife 2 would receive her proportionate (and inflationary protected) share of his final accrued benefit equal to 16.6 percent of his pension (50 percent x final accrued benefit x 10/30). In this manner, both ex spouses would receive, in the aggregate, 50 percent of his final accrued benefit and he would receive the remaining 50 percent.

This makes perfect sense from both a mathematical and equitable standpoint, because he was married for the entire 30 year period (that is, his entire 30 year pension will be deemed marital property); therefore, he will receive his 50 percent share of such marital property rights and the two ex spouses will share in the remaining 50 percent portion of his benefits based on the pro rata duration of their marriage to the participant.