4.1.b What is vesting?
Perhaps you have heard the phrase, “He is only 40 percent vested under the profit-sharing plan.” What does this mean? Most defined contribution plans have vesting clauses that apply to employer contributions. The word vesting refers to that portion of the employee’s total account balance that he or she has earned. It’s the amount that’s non-forfeitable even if he or she were immediately to quit or retire. The portion of a participant’s benefits that are considered vested cannot be taken away. For example, many 401(k) plans have a vesting schedule as follows: After one year of service, the employee may become 20 percent vested in the contributions made to his or her account by the employer. The next year, the employee will be 40 percent vested in those contributions; the year after that, 60 percent vested, and so on, until he or she becomes 100 percent vested after five years of service. If a plan participant quits employment after two years of service, when he is 40 percent vested, this means that he or she is eligible to receive only 40 percent of the value of the contributions made to the plan by the employer. The remaining 60 percent is lost and forfeited back to the plan. The amount that is lost is often referred to as a forfeiture.
A plan’s vesting schedule, however, never applies to plan contributions made by the employee through voluntary payroll deductions. These employee contributions are always considered 100 percent vested. So, if your ex-husband elected to contribute a portion of his own paycheck to the plan, via convenient payroll deductions, he will always be 100 percent vested in his own contributions. These contributions can never be taken away from the employee or otherwise forfeited. Even if an employee quits after two years on the job, when he or she is only 40 percent vested in the contributions made by the employer, he or she will still be entitled to receive 100 percent of any employee contributions made to the plan during the two years of employment.
4.2 Defined benefit pension plans
The second type of retirement plan is called a defined benefit pension plan, a plan that pays out benefits in the form of a monthly pension check when someone retires. Unlike a defined contribution plan, such as a 401(k), generally no individual accounts are maintained under a defined benefit pension plan. This fact alone distinguishes it from a defined contribution plan. A defined benefit pension plan is merely a promise (albeit a contractual one) that the company makes to its employees to provide them with a monthly “pension check for life” once they retire. A participant’s pension benefits are normally based on a plan formula that typically includes years of service with the company as well as the average salary earned by the employee during the final years of employment. A participant is generally not entitled to receive a lump sum distribution under a defined benefit pension plan. The benefits are typically payable only in the form of a “monthly lifetime annuity” starting when the participant retires, which ensures that the participant will receive a monthly pension check for the rest of his or her life.
Because account balances are not maintained for people under a defined benefit pension plan, it’s difficult for employees and their spouses to get a feel for the true value of the plan. That’s why benefits accrued by participants throughout their career under defined benefit pension plans are more of a mystery. That’s why employees who are only 30 or 40 years old may know that they will someday be getting a pension check each month when they retire, but they cannot tell you how much it will be. Nor can they tell you how much their eventual pension is worth in today’s dollars. And there’s the rub. During a divorce, it’s critical for a divorce attorney to attach a lump sum “value” to all of the marital assets, including the pension. While it’s relatively simple to determine the value of a defined contribution plan simply by looking at the latest plan statement, it’s a different matter entirely when it comes to your ex-husband’s defined benefit pension plan.
For discussion purposes, when I use the words “pension plan” throughout this book, I am referring to a “defined benefit pension plan.” The amount of benefits that a participant is entitled to receive under a pension plan is called his or her accrued benefit. Therefore, if an employee retires at age 65 with an accrued benefit of $2,000, he or she will receive a $2,000 monthly pension check for the rest of his or her life. Because no individual accounts are set up for employees under a pension plan, never use the words “account balance” when discussing your ex-husband’s pension benefits.
Now, the all-important question. At your divorce, how much of your ex-husband’s pension benefits are you entitled to receive as your marital share? The answer is not simple. Trying to determine how much a pension plan is worth is a difficult task even for attorneys. Quite often, divorce attorneys will hire an actuary or other pension professional to evaluate the pension. In order to evaluate your ex-husband’s accrued benefit under the pension plan at the time of your divorce, the pension professional must figure out the “present-day lump sum value” of his anticipated future monthly stream of retirement income. Just knowing that your ex-husband has earned an accrued benefit of $800 per month (as calculated by his employer) at the time of divorce does not answer the question. Under a pension plan, a participant generally cannot receive his full, unreduced accrued benefit until he reaches the plan’s normal retirement age (usually age 65). And even if you did know that his monthly accrued benefit was $800 when you divorced, what does this currently mean in terms of an immediate lump sum dollar amount? This is why it’s necessary for the attorney to hire a pension professional. They must determine, in today’s dollars, how much a future lifetime pension is worth. To do this, they incorporate such factors as mortality tables and interest rate charts.
Let’s look at an example: Assume that John, age 45, has worked at an auto company for the last 20 years. Based on the plan formula, his accrued benefit is calculated to be $1200 per month. This means that if John were to quit his employment today, he would be eligible to receive $1200 per month for his entire lifetime, starting when he turns age 65. It is not a measure of how much he could receive immediately on termination of employment. Now, assume that you are getting a divorce from John today. Your attorney’s pension evaluation expert would have to calculate how much John’s future $1200 monthly accrued benefit is worth in today’s dollars. This is called a present value. Based on actuarial statistics, which involves a lot of number crunching by the expert, his $1200 future monthly lifetime pension payments may have a present value of $120,000 today. Assuming that it’s all marital (that his pension was earned entirely during the marriage), you would be entitled to $60,000 today, as your equitable ownership share of the pension.
5. The Use of Offsetting Assets
Many attorneys choose to use other nonpension-related assets when dividing the pension benefits of the husband. For example, if your husband’s pension is valued at $120,000 at the time of divorce and you have equity in your home of approximately $120,000, perhaps the attorneys will work out a scenario in which you will get to keep the house and your ex-husband will keep his pension free and clear. However, because the value of the pension is quite often the largest marital asset, there may be no other offsetting assets to consider. In this case, your attorney must provide you with your own slice of your ex-husband’s pension benefits. This is done through a QDRO (as explained further in Chapter 2).
6. A QDRO Is a Must
In order to secure your share of the pension, your attorney must prepare a QDRO and submit it to the pension administrator for review and approval. QDROs are fairly complex creatures in their own right, and the vast majority of divorce attorneys do not understand how to draft them. Without a properly drafted QDRO, you may never see any portion of your ex-husband’s pension or 401(k) benefits, even though your divorce decree or separation agreement states in plain English that you are entitled to a portion of such retirement benefits.
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What Is a QDRO? (And Why Do You Need One?)
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