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Retirement Plans

We can be talking real money

Whoa, this is mine!

Defined contribution plans

Defined benefit plans

How do we divide it?

How can I spend it?

How should I invest it?

We can be talking real money

It's not unusual for one or more retirement plans to constitute the largest asset of the marriage when it comes to property division. And it's common for the retirement plans to be a significant asset of the marriage.

Unlike other major assets, however, retirement plans are less visible. It's easy to ignore them in working toward a settlement of your divorce. Don't.

Whoa, this is mine!

A key consideration in analyzing the division of retirement plans in divorce is the visceral response many employees have to a suggestion that their retirement plan might need to be shared. I tend to believe that I'm the one who scraped and slaved all those late hours, I'm the one who put up with that impossible boss, and I'm the only one entitled to enjoy the fruits of my labors in the form of my retirement plan(s). It's normal for me to feel this way. It's also often wrong.

Most states recognize the retirement plans earned by both spouses in a long-term marriage to be marital assets, available for division with the other spouse. That doesn't necessarily mean every retirement plan should be divided between the spouses, but it does mean the value of the retirement plan needs to be taken into account in negotiating an overall settlement.

Defined Contribution Plans

Before we can begin putting a value on a retirement plan, a primer about retirement plans is probably in order. Retirement plans come in all shapes, sizes, and flavors, but all retirement plans break down into one of two groups. Each plan is either a defined contribution plan or a defined benefit plan.

A defined contribution plan is a bucket of money with the employee's name on it. It involves a stated dollar contribution made to the plan periodically, either by the employer, the employee, or both. The plan balance changes (hopefully increases) each year. The change is based on what contributions get made to the plan and on whether and to what extent the money in it grows with earnings (capital gains, dividends, interest, etc.)

Examples of defined contribution plans are 401(k), 403(b), and profit sharing plans. Defined contribution plans have become increasingly common as defined benefit plans have become less common.

The balance in a defined contribution plan is constantly changing, but its value is ascertainable at any given point. Most employees receive an updated statement at least once a year.

Defined Benefit Plans

A defined benefit plan works differently. It's not a bucket of money. There's no stated dollar contribution to it for each employee. Instead, the employer makes a promise to pay a benefit to the employee at some point in the future.

Usually, the amount promised is a function of some kind of formula, often based on the employee's pay rate near the end of his or her career and the number of years the employee worked before retirement. This promise to pay is usually geared to the "Normal Retirement Date," typically age 65 or 67.

The employee typically can start drawing benefits before the Normal Retirement Date, but the payments will be reduced (and they're reduced for the life of the employee, not just until the normal retirement age). For example, an employee who begins drawing benefits at age 55 instead of 65 can expect to receive about half the normal benefit.

The "normal" benefit for a married participant in most defined benefit plans is called a Joint and Survivor Annuity. The Joint and Survivor Annuity pays a stated benefit to the participant from his or her retirement date until his or her death. On his or her death, his or her surviving spouse will receive a reduced percentage (typically 50% of the original benefit) until the spouse dies.

During marriage, a participant can't opt for a benefit that cuts out his or her spouse without the spouse's consent. On divorce, however, the spouse's rights get cut off automatically.

Because the defined benefit plan is simply a promise and not represented by dollars today, it's more complicated to put a value on it. The current value of a defined benefit plan is a function of four factors:

  • the formula benefit promised;
  • the age of the employee;
  • the health of the employee; and
  • how many years will intervene before the normal retirement age.
I have purchased (and many other lawyers and mediators have purchased) software that allows us to produce an approximate value for a defined benefit plan (which is accurate enough for most situations). You can call a lawyer or mediator who owns the software, or you can buy a copy for yourself. It's called Divorce Math, and you can get it from FinPlan in Chicago for about $400. The toll-free number for FinPlan is (800) 777-2108.

A caveat is probably in order here. I think that Dennis Casty at FinPlan has done a great job with his Divorce Math software, but if you expect to be presenting evidence in divorce court about the value of a pension plan, you'll probably need to get an evaluation from a professional actuary. Unless your judge uses Divorce Math (and many do), he or she will probably place more trust in an actuary than in a report generated by computer software.

How do we divide it?

First, make sure a division is the right thing to do. Often, a non-participant spouse will insist on a portion of the retirement plan because she thinks she's supposed to. (I apologize for the gender-specific reference, but the non-participant usually is the wife.) As I've already said, though, retirement plan dollars are not easy to spend for current needs, and sometimes the non-participant spouse needs ready cash much more than she needs a retirement nest egg. She might be better off to bargain to give up rights to the retirement plan(s) in return for more cash or other liquid assets.

Let's assume the husband and the wife have agreed, however, that they want to transfer some of the retirement plan wealth from one spouse to the other. If the wealth is held in several different accounts (as it often is if the participant has worked for multiple employers), they could simply transfer one of the plans outright.

If the assets are held in one large account, and that account is an Individual Retirement Account, the husband and the wife can agree on a transfer of any portion of it.

If the assets are held in one large account and that account is in a company-sponsored retirement plan, the husband and the wife won't be able to make a simple transfer. They'll need to use a Qualified Domestic Relations Order (sometimes called a "QDRO" and pronounced "QUAD row."). A QDRO isn't cheap, but it may be the right solution when nothing else works to allow you to make the transfer you've agreed is appropriate. There's a separate page all about QDRO's, if you're interested.

A QDRO will almost always be simpler, cleaner, and cheaper for a defined contribution plan than for a defined benefit plan. So if you're dealing with both kinds of plans, you may want to try to arrange the values so the QDRO deals only with the defined contribution plan.

Let's review the order of preference for plans used to transfer retirement plan assets:

  • First choice: IRA's, because you don't need a QDRO at all. You just instruct the trustee to transfer the money directly from one IRA to another.
  • Second choice: Defined contribution plans, because although you need a QDRO, it can be a fairly simple and straightforward QDRO.
  • Third choice: Defined benefit plans, because the QDRO needed will be complicated. Many lawyers don't even realize how scary it is to do a QDRO on a defined benefit plan. I think there are QDRO's all over America that are time bombs waiting to generate malpractice claims against lawyers, but that's not your problem.
In any transfer of qualified retirement plan money, it's crucial that you visit with your attorney or tax advisor before you make the transfer. It's far easier than it should be to lose the tax-deferred status of retirement plan money by a careless or ill-advised transfer. This could mean a huge loss for you in tax benefits if you don't get good advice before you make the transfer.

How can I spend it?

Qualified retirement plans are an excellent way to build wealth for retirement. They're usually a lousy way to save for current needs. Typically, the only way to withdraw money from a qualified plan and spend it before age 59 ½ is to pay a 10% penalty - that's money you just lose.

There are two exceptions to this rule that may be relevant to you and your spouse. One is that the distribution of 401(k) money to a spouse in divorce using a QDRO is not subject to the 10% penalty. To make this work, the distribution must be directly to the spouse, not first to an IRA in the spouse's name.

The other exception is one used by many people, perhaps too many people. Company plans differ, but many of them allow employees to borrow against their qualified plan balance. You have to pay interest, but the interest you pay goes back into your account balance as earnings. The main problem with borrowing against your qualified plan balance is the risk that you won't pay it back and therefore that you will lose the retirement benefit the plan is designed to provide.

There are some other exceptions, but most of them aren't helpful for most people. For example, you can begin withdrawing money before age 59 ½ if you receive the money on a schedule intended to last for the rest of your life. For most people, those are very small payments, however, so this option is rarely used. The rule about early withdrawals is a powerful incentive for leaving money in a qualified plan until retirement or death.

One other expense to keep in mind: whenever you pull money out of a qualified plan, even if you wait until your retirement age, you will always have to pay federal and state income tax on it at your applicable rate.

How should I invest it?

Whole books have been written on this subject, and I couldn't possibly do it justice here. Suffice it to say, however, that the investment strategy for your retirement plan should be a function of two factors:

  • how averse are you to risk?
  • how soon will it be that you'll need to begin withdrawing the money?
On the first subject, you can gauge how averse you are to risk by asking yourself the question, how nervous do I get or would I get when I see the value of my investment go down rather than up?) If you get really nervous, steer clear of equity investments (stocks) or at least mix in some more stable assets with them, because almost all of them have cyclical upswings and downturns.

On the second subject, if you're several years away from needing the money, and you determine that you can watch your investment rise and fall without losing sleep over it, you probably should invest in equities. The past is not always the best guide to the future, but statistically, equities on the whole have outperformed most other investments in the past.

Equities tend to rise and fall in value, however, so if you're within a few years of needing to withdraw money, you should tilt your investment mix more heavily toward investments that are unlikely to decline in value. They may not grow as fast, but you'll have peace of mind that you won't lose value on the eve of a large withdrawal.

T. Rowe Price has a nifty service to help you think through your personal investment strategy. You might also want to check with Quicken.com and their page on Building Your Plan. It takes a while to load but seems to give sound advice. Central Pacific Bank in Hawaii has a nice Retirement Planning Calculator.

 

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