The Early Retirement Subsidy
This is one of the most complicated
and misunderstood aspects of a defined benefit pension plan.
Under most defined benefit pension plans, the normal retirement
age is 65. This means that a participant can retire at age
65 and receive his full, unreduced accrued benefit. Generally,
an "accrued benefit" can be calculated at any
point in time during a participant's career. For example,
if a 40-year-old employee at Company XYZ is getting divorced
today, the attorneys in the case usually want to know what
his accrued benefit is today. While this calculation is
oftentimes a moot point if a coverture-based QDRO is utilized,
it is still important to know the participant's current
accrued benefit in order to calculate the present value
of his pension as of the date of divorce. Let's assume that
his accrued benefit is calculated to be $600 per month today
based on his current years of service with the company,
his current average monthly compensation and the current
plan formula. This does not mean that the participant would
receive $600 per month right away if he were to quit his
job. The term "accrued benefit" inherently refers
to the pension that the participant would receive on an
unreduced basis commencing at his normal retirement age
of 65. If he did quit his job today, his $600 monthly pension
would be deferred for the next 25 years until he attained
the age of 65. At that time, he would commence his monthly
$600 lifetime pension.
The vast majority of defined
benefit pension plans include early retirement provisions
of some sort that afford participants the opportunity to
retire before their normal retirement age. A plan with a
normal retirement age of 65 may permit participants to retire
with their full, unreduced accrued benefit after they attain
a specified age and complete a specified number of years
of service.
For example, Company XYZ
may offer an unreduced accrued benefit to anyone who retires
at age 60 with 10 or more years of service. Therefore, a
60-year-old who retires early can receive his unreduced
accrued benefit that would otherwise commence on his 65th
birthday. Had the plan not contained this early retirement
subsidy provision, the participant's benefits would have
been actuarially reduced to reflect the fact that his pension
began 5 years before his normal retirement age. Many companies
will also permit employees to retire early, say at age 55,
and receive slightly reduced benefits in accordance with
an early retirement reduction schedule. For example, an
employee with an accrued pension of $2,000 per month may
elect to retire early at age 55 and receive a pension of
$1,800 per month commencing immediately. In other words,
his pension is only reduced by $200 per month even though
he is commencing the benefit a full 10 years before his
normal retirement age of 65. This relatively slight reduction
pales by comparison to the actuarial reduction that would
have been imposed if the plan did not include an early retirement
incentive. From an actuarial standpoint, a participant's
pension may be reduced by up to 60 percent when electing
commencement 10 years early. In our example above, rather
than receiving $1,800 per month for life, the participant
would only receive $800 per month if the plan did not contain
an early retirement provision. The early retirement subsidy
is equal to the value of the early retirement pension actually
received by the participant less the value of the pension
he would have received with a full, actuarial reduction
imposed.
In essence, the company is
"kicking in" an extra $1,000 per month for life
(ie: he'll receive $1,800 vs. $800 per month). They are
subsidizing a large part of his pension via the elimination
of the significant actuarial adjustment.
While pension plans have
contained early retirement provisions for decades to encourage
employees to retire before their normal retirement age,
the term "early retirement subsidy" was not coined
until the enactment of the QDRO laws in 1984. Before 1984,
such a term was not necessary. A participant could simply
retire before his normal retirement age, to the extent permitted,
and receive a full, or slightly reduced pension for life--end
of story. Now enter the QDRO. Because QDROs permit an alternate
payee to commence benefits before a participant actually
retires, she can only receive her share of the benefits
on an unsubsidized basis. Remember, early retirement subsidies
were meant as an enticement for the employee to retire early.
They were not meant to be a "bonus" for the alternate
payee to commence benefits early. Therefore, when the first
QDRO hit the streets in 1984, companies (and plan actuaries)
were required to calculate something they never before had
to calculate; namely, what the alternate payee would receive
on an unsubsidized basis if she chose to start her share
of the benefits before the participant actually retired.
They referred to this difference in the subsidized value
of the accrued benefit and the nonsubsidized value as the
early retirement subsidy.
Because the early retirement
subsidy is part and parcel of the participant's accrued
benefit, it should be considered as a marital asset subject
to equitable distribution upon divorce. As a co-owner of
the pension, the alternate payee should be entitled to receive
a pro-rata share of any early retirement subsidy payable
to the participant under the plan. After all, if the plan
does not actuarially reduce the participant's marital share
of the pension upon retirement, why should the alternate
payee's share of the pension be artificially reduced.
The following horror story
will help put this equitability issue in perspective. Bill
is employed at Company ABC. He is currently age 60 with
an accrued benefit of $2,000 per month. He could retire
today if he so chose, and receive a fully subsidized accrued
benefit of $2,000 per month. In other words, his $2000 accrued
benefit which would typically become payable at his age
65, will be payable to him immediately if he elects to retire
early at age 60. In this case, the company is fully subsidizing
his entire accrued benefit. A QDRO is submitted and approved
by the plan administrator which provides his former spouse,
Mary, with 50% of his total accrued benefit. Because it's
all marital, her 50% share of the benefit is calculated
to be $1,000 per month. Mary contacts the plan administrator
and tells them that she would like to start receiving her
$1,000 per month right away. Remember, because Bill has
already attained the plan's earliest retirement age, she
could commence her benefits under the QDRO immediately.
However, unbeknownst to Mary, she can only commence them
on an "unsubsidized basis", because Bill is still
working. He has not triggered any early retirement subsidy
yet. The plan administrator tells Mary that if she elects
to commence her share of the benefits right away, she will
only receive $500 per month rather than $1,000 per month.
This reflects the fact that she is starting her benefits
a full five years before Bill's normal retirement age of
65. And because Bill is still working, the plan will actuarially
reduce her $1,000 per month assignment to reflect an age
60 commencement of benefits. Incidentally, when Mary talked
to Bill a few days earlier to inquire when he anticipated
retiring, he indicated that he would probably retire in
the year 2009. Because she is desperate to start receiving
benefits, she tells the plan that she is willing to take
the "big hit" (ie: the full actuarial reduction)
and receive $500 per month. On February 1, 1999, she receives
her first monthly check in the amount of $500. The next
day, Bill elects early retirement and starts to receive
$1,500 per month for life. Because the QDRO was silent on
the issue of the early retirement subsidy, Mary is receiving
$500 per month for life and Bill is receiving $1,500 per
month for life. When Bill retired just one month after Mary
elected to commence her share of the benefits, he was eligible
for the early retirement subsidy. And because Mary was not
entitled to any of the subsidy pursuant to the QDRO, Bill
is receiving the entire early retirement subsidy. From an
equity standpoint, the court intended that each party was
to receive 50% of his $2,000 monthly pension (ie: $1,000
to each party). In reality, Bill is receiving three times
the amount that Mary is receiving. This is the trap that
attorneys can fall into when drafting a QDRO that does not
include early retirement subsidy language for the alternate
payee. Also, you should be sure to include "recalculation"
language in the event the participant subsequent retires
early after the alternate payee has already commenced benefits.
However, even if your QDRO does include recalculation language,
all of the subsidy could be lost for the alternate payee
if the participant delays retirement until his normal retirement
age. See the discussion below in Section 6.3 regarding the
danger of the diminishing early retirement subsidy.
Dangers of the Diminishing
Early Retirement Subsidy
Neither a QDRO nor offsetting
assets may protect nonparticipants from their own actions.
This is especially true when dealing with early retirement
subsidies under QDROs. Nonparticipants may unwittingly lose
a significant portion of the pension by choosing to commence
their share of the benefit before the participant has actually
retired. Even a properly drafted QDRO can be defeated by
poor judgment on the part of the nonparticipant. Knowledge
of early retirement subsidies and the limitations imposed
by federal QDRO laws is essential to making informed decisions
regarding the commencement date of the nonparticipant's
share of the pension.
Unless the nonparticipant
urgently needs to start her pension before the participant
retires, it may be in her best interest to delay commencement
until the participant's actual retirement date.
This section may seem esoteric
but can have a huge impact on the nonparticipant's share
of the pension. Unbeknownst to the nonparticipant (and her
attorney), a savvy plan participant can reap a significant
percentage of the pension that was earmarked for the nonparticipant.
Under ERISA and applicable
sections of the Internal Revenue Code, an alternate payee
under a QDRO may receive a portion of the participant's
early retirement subsidy only on or after his actual date
of retirement. Therefore, if the alternate payee elects
to commence her share of the benefits before the participant
actually retires, her share will be actuarially reduced
automatically to reflect such early commencement. Many plan
administrators do, however, permit a QDRO to provide that
her reduced unsubsidized share of the pension be "recalculated"
upon the actual retirement of the participant in order to
provide the nonparticipant spouse with a pro-rata share
of any early retirement subsidy payable to the participant.
Let's look at another example.
A Teamster, aged 55, with 30 years of service, currently
has an accrued subsidized benefit of $2500 per month, payable
on an unreduced basis should he retire immediately. Since
he has already met one of the plan's early retirement provisions,
the alternate payee may elect to receive her half of the
pension now, even though the participant himself may continue
working. However, her 50 percent share will not be based
on his $2500-per-month subsidized pension. Instead, she
receives only half of the unsubsidized accrued benefit,
which may amount to only $550. Her share is actuarially
reduced to reflect her early commencement of benefits.
A QDRO could provide that
her share of the benefits be recalculated upon his actual
retirement under the plan. In this manner, if he retires
one year later with a subsidized monthly benefit of $2600
per month, she may be entitled to a pro rata share of this
larger pension on a prospective basis. Her share of the
pension could instantly grow from $550 per month to $1300
per month.
The great danger to the nonparticipant
spouse is the delayed retirement of the participant and
its impact on her share of the pension. Remember, an early
retirement subsidy is payable only to the participant who
retires before his normal retirement age. If a participant
delays retirement until his normal retirement age, the entire
pension will be considered a "normal retirement pension"
and no early retirement subsidy will become payable. The
result? Even if your QDRO contained recalculation language
for early retirement subsidy purposes, the nonparticipant's
share of the benefits will not increase, because technically
the early retirement subsidy disappeared at his normal retirement
age. Because he delayed retirement until age 65, there is
nothing to recalculate. No subsidy will be payable to the
participant.
In our example, the alternate
payee's $550 pension would become fixed at this amount for
the remainder of her lifetime. Upon the participant's retirement
at his normal retirement age, he would receive the balance
of his then $3000 monthly pension. When representing nonparticipants,
it is imperative that you make them aware of the staggering
reductions that can take place if they desire to start their
share of the pension before the participant's actual date
of retirement. They should also be aware of the possibility
that the entire early retirement subsidy could be forfeited
by the carefully anticipated actions of the participant
(that is, intentionally delaying his retirement for a number
of years to eliminate the possibility of any enhancements
to the nonparticipant).
What are Early Retirement Window Programs?
(aka Limited "Buy-Out" Offers)
In this era of corporate
downsizing, many companies try to encourage "certain"
eligible employees to retire early in addition to their
other standard techniques of layoffs and forced terminations.
In other words, the pension plan's standard early retirement
provisions do not provide enough of an enticement to call
it quits for many middle-aged employees. As a result, many
companies will sponsor an early retirement window program
for certain eligible employees. These are essentially limited,
one-time buy-out offers in which they offer enhanced pension
benefits above and beyond what the employees would receive
under the standard early retirement provisions of the plan.
These buy-out offers come in many shapes and sizes. For
example, a company may:
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add a specified number of years of service
to the employee's actual number of years of service
(Five years is common. Therefore, an employee with 25
years of actual service would be treated as if he had
30 years of service for pension calculation purposes).
|
| • |
add a specified number of years to the employee's
age (ie: a 58 year old employee could magically become
63 years old. This would result in a smaller early retirement
reduction because the participant would only be considered
two years away from his normal retirement age of 65,
rather than 7 years shy.)
|
| • |
provide an additional temporary or lifetime supplemental
pension in addition to the employee's standard pension
benefit. (For example, the participant may receive an
additional $500 per month for life, if he elects to
retire under the early retirement window program.)
|
| • |
provide employees with the limited opportunity to
elect their benefits in the form of an immediate lump-sum
cash payment rather than a monthly lifetime annuity.
(Remember, cash distribution options are typically not
available under most defined benefit pension plans.)
|
| • |
provide any combination of the above. |
The basic question that
enters the divorce arena is this. Should post-divorce enhanced
benefits awarded to a participant under a limited early
retirement window program be considered marital property
subject to equitable distribution for QDRO purposes? In
other words, should the QDRO when drafted, provide the alternate
payee with a pro-rata share of such enhanced benefits? Or
if the QDRO is silent on this issue, should the plan administrator
automatically incorporate these enhanced benefits into the
calculation of the alternate payee's assigned share of the
benefits?
The attorney that represents
the participant would argue that the enhanced benefits belong
solely to the participant:
1. After all, these enhanced
benefits did not accrue during the marriage.
2. Further, these benefits
were not previously funded by the plan during the participant's
years of service earned during the marriage.
3. It can also be argued
that the enhanced benefits represent replacement for lost
wages as a result of a quasi-forced termination of employment.
The alternate payee's attorney
will counter with the following arguments:
1. The enhanced benefits
should be shared by the parties because a properly drafted
coverture-based QDRO bases the alternate payee's share of
the benefits on the participant's actual (ultimate) pension
at retirement.
2. Also, early retirement
window programs are generally only offered to certain long-serviceemployees
who were married during the period in which they accrued
enough years of service to qualify for the enhanced benefits.
In other words, if the employee was married for 24 years
and two years after the divorce, the company offered the
buy-out to anyone with over 25 years of service, it can
be argued that a majority of the service requirement was
earned during the marriage and therefore, the enhanced benefits
are subject to equitable distribution.
3. These enhanced benefits
represent a form of early retirement subsidy which should
be shared by the parties.
4. The terms of the early
retirement window program are made a part of the pension
plan through an official amendment to the plan and therefore,
are part and parcel of the participant's actual pension
benefits. They do not represent a severance package that
is outside the scope of the qualified pension plan and which
may be intended as a replacement for lost future income.
5. A strong argument can
also be made that if the buy-out offer was not available
to the employee, he would in all likelihood remain employed
with the company, in which case the alternate payee would
receive the appropriate inflationary protection via his
continued increases in the pension through a properly drafted,
coverture-based QDRO.
Because of the variety of
circumstances in each case, the diversity of benefit enhancements
and the strong arguments on each side of the case, the answer
is not simple. Whether the alternate payee shares in any
buy-out offer through a QDRO should be decided on a case
by case basis. Also, this situation really only crops up
when the QDRO utilizes the traditional coverture approach.
If the QDRO provided the alternate payee with 50% of the
participant's accrued benefit frozen as of June 1, 1996,
for example, this is a moot point. Any enhanced benefits
in this case would, of course, belong to the participant.
In Reinbold v. Reinbold,
1998 WL 238745, the Appellate Division of the Superior Court
of New Jersey held that the former nonparticipant spouse
was entitled to a share of the participant's enhanced benefits
through an early retirement window program. Certain eligible
participants would receive an additional five years added
to their actual years of service and an additional five
years added to their age.
The participant argued that
the enhanced pension was not earned during the marriage
but was a replacement for his future earnings, which would
otherwise have been his separate property. The appellate
court stated that "Whether the enhanced pension is
includable in the marital estate depends upon the nature
of the property and how it was earned...Accordingly, we
determined that the husband's pension was includable as
marital property and that it could not be excluded from
the distributable estate because of the fortuitous timing
of the failure of this marriage." Using logic from
Whitfield v. Whitfield, 222 N.J.Super. 37, 535 A.2d 986
(App.Div 1987), which dealt with a member of the military,
the Whitfield court stated that "These parties were
married for sixteen years during which time they experienced
all of the joys and sorrows of married life. They raised
three children. It is uncontroverted that they labored,
shoulder to shoulder in the military, establishing homes
and supporting their family, both financially and emotionally,
all over the world. During the entire marriage, defendant
was accumulating credits toward his pension which both parties
anticipated he would receive in 1988. Clearly, this pension
will not be earned on the 20th anniversary of defendant's
entry into the service. Rather, it was earned during each
and every day of his 20 years of employment in the military,
16 of which were spent in military, 16 years of which were
spent in a "shared enterprise" with plaintiff."
It's also important to review
how the appellate court in Reinbold actually divided the
participant's total benefit including the enhancements.
Here, the court stated, in pertinent part: "We turn
finally to the issue of what the denominator of the coverture
fraction should be in this case. Is it 28/30 which would
reflect the actual years worked by defendant or 28/35 reflecting
the years added to his service by the company? we think
the former is the correct denominator because it reflects
reality. Defendant worked two years after the filing of
the complaint before he retired. Thus 28/30 reflects the
differential between employment during coverture and further
employment. the gift of 5 extra years of service should
not be used to reduce plaintiff's fractional share of the
pension when no work was actually performed for that service."
We agree.
Impact of Early Retirement
Supplements on QDROs
To carry the early retirement
theme further, this article will discuss another form of
benefit enhancement that is oftentimes provided to employees
under a many defined benefit pension plans--early retirement
supplements. These additional supplemental payments are
intended to encourage employees to consider taking early
retirement before the attainment of their normal retirement
age, which is usually age 65. Companies would much rather
hire younger employees at lower wages to replace lower and
middle-management employees in their fifties and sixties.
While the participant's accrued benefit may be reduced to
reflect his or her early commencement of benefits at age
55, the plan may also pay a monthly supplemental pension
benefit until the participant attains the age of 62, for
example (which is the age that the participant may become
eligible for Social Security benefits). The official names
of these temporary monthly benefits vary by company. Some
plans refer to them as temporary benefits, supplemental
benefits or Social Security supplements. Whatever the name,
you should be sure that the alternate payee is provided
with a proportionate share of these temporary or supplemental
benefits when you draft the QDRO. Also, these supplemental
benefits may be temporary in nature, or they may be payable
to the participant for life.
As a co-owner of the pension,
the alternate payee should be entitled to share in these
supplemental or temporary benefits. Remember, these supplements
do not simply arise out of thin air. They don't represent
a bonus that's simply separate property of the participant.
These are part and parcel of the pension plan itself and
they are funded for during the working careers of plan participants.
The provisions for these supplemental or temporary benefits
can be found within the terms of the pension plan itself.
Do not confuse these supplemental or temporary benefits
with a limited, one-time buy-out offer that the company
may offer to certain eligible employees from time to time
during a stand-alone early retirement window program.
Most temporary or supplemental
benefits payable under a defined benefit pension plan are
just that. They usually drop off when the participant reaches
a certain specified age. If you base the alternate payee's
share of the benefits on a "percentage basis",
including a specified percentage of any temporary or supplemental
benefits that may become payable under the plan from time
to time, this is fine. You may run into trouble however,
if your QDRO includes a "specific dollar amount"
to be payable to the alternate payee.
The following horror story
is true. I have witnessed several cases where the participant
is already retired and receiving a monthly pension of, say,
$2,000 at the time of divorce. You prepare a QDRO that provides
the alternate payee with $1,000 per month because all of
the pension was deemed marital. However, what none of the
parties may realize, when the retiree reaches the age of
62, his temporary monthly benefit of $800 will drop off
and he will only receive $1,200 per month for the rest of
his lifetime. Again, if your QDRO simply provided the alternate
payee with $1,000 per month until the earlier to occur of
his death or the alternate payee's death, an inequitable
situation will arise when the retiree reaches the age of
62. He will receive a monthly pension of $200 while his
former spouse receives $1,000 per month. If you represent
the participant in a divorce proceeding, be sure that any
temporary or supplemental benefits payable to the alternate
payee under the QDRO drop off in a proportionate manner
at the same time as the participant's temporary or supplemental
benefits drop off. Otherwise, you may be calling your malpractice
carrier.
