Put Your Actuary to Work - Valuing the Pension

BY SANDOR GOLDSTEIN

(Published in the Fall, 2001 issue of the Family Advocate, a Journal of the American Bar Association.)

Retirement benefits under defined benefit pension plans can represent the largest single asset for distribution in the event of dissolution of marriage.  In virtually all cases, pension benefits, whether vested or non-vested, matured or unmatured, are treated as property to be taken into account in the division of property between spouses.  In recent years, actuaries have been playing an increasing role in assisting attorneys in valuing retirement benefits.


Types of Retirement Plans

Retirement plans fall under two basic categories – defined contribution plans and defined benefit plans.  Under a defined contribution plan, the contribution to be made to the plan on behalf of participants is defined.  Contributions are allocated to individual accounts established for each participant.  The accounts will normally be credited with investment gains or losses, and the account balance will be paid out as the benefit.  Thus, benefits under defined contribution plans are easy to value.  The value of an employee’s accrued benefit is simply the current balance in the employee’s account under the plan.  Some actuarial help may be needed if there was a pre-marital account balance and it is necessary to determine the current value of the pre-marital account balance.  Plans such as profit sharing plans, 401(k) plans, and savings plans fall under the category of defined contribution plans. 

Under a defined benefit pension plan, the employer makes a commitment to provide a specific amount of pension at retirement, i.e. promises to pay a defined benefit.  The amount of pension to be provided is generally based on the employee’s length of service and salary history.  Considerably more complications are involved in valuing retirement benefits under defined benefit plans than under defined contribution plans.  The problem involved is to determine the value at the current time of the right to receive certain pension payments beginning at some future date.  An actuary is generally needed to carry out the calculations.


Approaches For Dividing Retirement Benefits

Courts generally use one of following two basic approaches for dividing retirement benefits:

1.      Present Value Method.  Under this method, a present value for the marital portion of the benefit is determined.  The non-employee spouse is then awarded other marital property equal to his or her share of such present value.  The employee spouse is awarded the full retirement benefit. 

2.      Reserved Jurisdiction or Deferred Division Method.  Under this method, each spouse is awarded an appropriate portion of the retirement benefits, “if, as, and when” they are paid.

Under the present value method, an actuarial valuation is needed to determine the value of the benefits payable from a defined benefit pension that is to be treated is marital property.  The goal of the actuarial valuation is to provide a reasonable and objective assessment of the value of retirement benefits that are considered to be marital property.


Selecting and Working With An Actuary

An actuary is someone who is professionally trained to assess the financial impact of future contingent events.  Actuaries generally work for insurance companies and employee benefit consulting firms.  In the pension area, actuaries are involved in funding and valuation of retirement plans.

Over recent years, actuaries have played an increasing role in assisting attorneys in determining the value of accrued pension rights in dissolution of marriage cases.  Other professional experts such as C.P.A.’s and economists have also been used.  But, since actuarial calculations are involved, an actuary is generally best trained to perform such calculations.  In addition, actuaries who work in the pension area will have more experience in interpreting plan provisions and using appropriate mortality tables than other professional experts.  It should also be kept in mind that the actuaries are required to follow certain standards that govern the practice of actuaries in the area of valuations of pensions for domestic relations cases.  The standards have been developed by the Actuarial Standards Board and are titled “Actuarial Practice Concerning Retirement Plan Benefits in Domestic Relations Actions”.

In selecting an actuary, attorneys should obtain information regarding the education, professional credentials, and experience of the actuary.  It is important to check whether the valuation report will be signed by a qualified actuary.  Actuaries obtain their credentials from one of several actuarial organizations.  The Society of Actuaries administers actuarial examinations which if successfully completed lead to the designation of Associate of the Society of Actuaries (A.S.A.) and Fellow of the Society of Actuaries (F.S.A.).  The Joint board for the Enrollment of Actuaries grants the designation of Enrolled Actuary (E.A.) to actuaries who complete certain examinations related to the pension actuarial field.

The actuary selected should be able to explain technical concepts in a relatively simple manner, in case court testimony is needed.  


Information to Provide to the Actuary

The information needed to do an evaluation will vary to some extent with the specific retirement plan.  But, attorneys should generally provide at least the following information to the actuary in order to perform an evaluation of a defined benefit pension plan:

1.                  The employee’s date of birth
2.                  The employee’s date of employment
3.                  The employee’s recent salary history
4.                  The employee’s accrued benefit under the plan
5.                  The employee’s date of marriage

If possible, a Summary Plan Description or plan booklet for the retirement plan should be obtained and provided to the actuary.  It is also important to tell the actuary about any unusual circumstances that may have an impact on the calculations, such as any serious medical conditions of the employee. 


Defining the Employee’s Interest Under a Defined Benefit Plan

The first thing that an actuary needs to do in order to value an employee’s benefit under a defined benefit pension plan is to define the employee’s interest under the plan as of the date of dissolution.  One of two approaches is generally used.

Under one possible approach, the employee’s interest is defined as the pension that the employee would be eligible to receive if her or she terminated employment as of the date of dissolution.  Calculations are based on the employee’s credited service and salary history as of that time.  This approach is sometimes referred to as the “Termination Approach”.

Another possible approach is to estimate the projected pension payable at retirement.  This projected pension is multiplied by a fraction, the numerator of which is the period of service up to the date of dissolution and the denominator of which is the total service at retirement.  This approach is sometimes referred to as the “Time Rule”.  It is generally not considered appropriate to take into account future salary increases in determining the employee’s interest.  Thus, under the “time rule” approach, it is common to assume that the relevant average compensation at retirement date will be the same as at the time of dissolution.

A possible objectionable feature of the “time rule” is that it takes into account service to be rendered by the employee after the date of divorce.  Thus, in using this approach, the actuary is assuming that the employee will remain in service until retirement.

In many cases, the “termination approach” and the “time rule” will produce the same amount of pension.  However, in certain cases, there may be significant differences between the pension amounts produced under the “termination approach” and the “time rule”. 

 

Defining the Marital Portion of the Employee’s Interest

Since courts will generally not divide property acquired before marriage, only the portion of the employee’s interest acquired during marriage is included in the valuation.  The following approach is generally used to determine the marital portion:

 

                                        Years of credited service during marriage
Marital Portion =                _______________________________________
                                        
                                        Total years of credited service at date of divorce

 

Actuarial Assumptions

An actuary needs to use certain actuarial assumptions in order to calculate the actuarial present value of an accrued pension.  These will generally include an interest rate assumption, an assumption regarding the age at which the employee is expected to retire, and assumed rates of mortality.  If the plan provides for automatic cost of living increases, an assumption regarding future cost of living increases also needs to be made.

An interest rate assumption needs to be made in order to discount future pension payments to present value.  This is usually the most significant assumption in terms of its impact on the present value.  As the objective of the valuation is to estimate a “market value” for the accrued pension, the interest rate used by the actuary should produce present values that are consistent with the current market prices of comparable annuities.  A commonly used practice is to use the interest rates published by the federal Pension Benefit Guaranty Corporation.  These interest rates are based on periodic surveys of the interest rates used by large life insurance companies in providing annuities.  Use of the Pension Benefit Guaranty Corporation interest rates has the advantage of producing present values that are in line with the market prices of comparable annuities.

If an unreduced pension is payable only upon attainment of normal retirement age, it is common to assume that the employee will retire at the normal retirement age.  But if the employee can retire with an unreduced pension before the normal retirement age, it is necessary for the actuary to make some assumption as to when the employee will retire.  Because the choice of the retirement age is generally under the employee’s control, the actuary may determine present values using several alternative retirement ages.  In this way, it is possible to present a range of present values.

Since we are valuing an employee’s interest in a pension benefit, it is generally appropriate for the actuary to use a mortality table that is based on experience for pensioners or annuitants, such as the 1983 Group Annuity Mortality Table.  The mortality table used should fairly represent the mortality of an employed person is average health, unless some specific information is available indicating that the person is in particularly poor health.  

 

General Comments Regarding Pension Valuations

The nature of an actuarial present value appraisal of an accrued pension is not always fully understood.  Attorneys will sometimes make arguments such as the following in attempting to question the results of a pension valuation: “What if the employee were to die tomorrow without receiving any pension payments?  How can you say his pension is worth $100,000?”

It needs to be kept in mind that an actuarial present value is a fair value without being a prediction of future realized value.  A fair value is not necessarily a prediction of exact value or of how long an employee will live.  It is a best estimate based upon probabilities of future events.  If present values are properly calculated, then future realized values will exceed present values about half the time and fall short the other half.

The methodology used by actuaries to determine the present value of a pension is frequently misunderstood.  Many attorneys believe that actuaries used a fixed life expectancy for an individual.  In determining the present value of a pension, actuaries generally take into account the probabilities of surviving to all future ages.  The sum of the present values of pension payments at all possible future ages represents the present value of the pension.

 

Some Issues to Look For in Reviewing Pension Valuations

Is a Fixed Life Expectancy Used to Calculate the Present Value of the Pension?  With a fixed life expectancy, for example age 80, it is assumed that the person will die at exactly age 80.  As it is very unlikely that the person will die at exactly that age, a more accurate approach is to use probabilities of surviving to various future ages, based on the mortality table.

Is the Mortality Table Used Based on the General Population?  Mortality rates based on the general population, such as those in the U.S. Life Tables, are generally higher than mortality rates of persons actively at work.  Since the person whose pension is being valued is either actively at work or retired, it is more accurate to use a mortality table for pensioners than a table based on the general population.

Is the Interest Rate Assumption Used to Discount Future Payments Appropriate?  Since the objective is to estimate the fair market value of the pension, the interest rate used should produce present values that are in line with the market prices of comparable annuities.  Thus, if the current market prices of annuities reflect an interest rate of 6% per year, an interest rate assumption of 8% per year would not be appropriate for determining the present value of the pension.

Is the Retirement Age Assumption Used Appropriate?  The retirement age assumption should reflect the age at which the employee can be expected to retire.  For example, if the employee can retire at age 55, but is not expected to retire until age 60, assuming retirement at age 55 would generally not be appropriate.