A thorny divorce problem: Splitting defined benefit plans
When a marriage is good, it is one of life’s greatest blessings. Unfortunately, while the divorce rate has been declining many marriages still suffer this fate. One study estimated the number of couples getting divorced in 2017 at roughly one million.
Some divorces are more contentious than others, especially when spouses disagree on how assets should be split. But even in amicable separations it’s not uncommon for an innocent misunderstanding to swell into animosity or hardship — or both.
On particularly thorny area: splitting a defined benefit plan. Unlike dividing a 401(k) or other defined contribution plan, which is often just a matter of asking the holder how much of the account they will give up, splitting a defined benefit plan also involves deciding how and when the division will occur.
The answer to this second question, which is less frequently discussed and less-understood, can have a huge impact on a divorcee’s long-term planning. It can impact when they receive a benefit from the plan, how much that benefit will be and, perhaps most importantly, when benefits will cease altogether.
The key is to understand the relative merits of the available approaches, and plan accordingly.
ENTER THE QDRO
Property settlements pursuant to a divorce are primarily a matter of state law. Those laws differ from state to state — especially in the context of separate property versus community property states — but absent a prenuptial agreement to the contrary, soon-to-be ex-spouses are generally entitled to receive an equitable distribution of marital assets in a divorce. Note: this is not necessarily the same as an equal distribution of assets or, as in the case of community property states, an equal distribution of the community property.
Given the ubiquity of retirement accounts, such distributions regularly include the splitting of IRAs as well as 401(k)s, pension plans and other employer-sponsored retirement plan assets. But while IRAs can be split with relative ease using a simple divorce decree or a marital separation agreement, ERISA-qualified plans, including both defined contribution plans like 401(k)s and defined benefit plans like pensions, are more complex.
Notably, ERISA Section 206(d)(1) provides that the benefits accrued under an ERISA-covered plan generally cannot be assigned or alienated. Similar language can be found in IRC Section 401(a)(13). Together, these rules give ERISA-covered assets their strong creditor protection, making it nearly impossible for anyone other than the account owner to receive benefits accrued under an ERISA-covered plan. And more specifically, ERISA Section 206(d)(3) and IRC Section 414(p) provide a relatively narrow exception to the anti-assignment and alienation rules.
In fact, these provisions would make it nearly impossible for even a soon-to-be-ex-spouse to receive any benefits accrued under the plan — if not for the subsequent language regarding Qualified Domestic Relations Orders, or QDROs, in both ERISA and the Internal Revenue Code.
Under these sections of the law, a QDRO can be used to assign all or a portion of a plan
’s benefits to an alternate payee — most commonly the participant’s ex-spouse, though it may also be the participant’s current spouse, child or other dependent to satisfy family support or marital property obligations.
RULES FOR QDROS
QDROs begin their lives as Domestic Relations Orders, or DROs. These are generally issued by state courts but may, in fact, be issued by any state agency or instrumentality with the authority to issue judgments, decrees or orders, or to approve property settlement agreements pursuant to state domestic relations law.
According to the requirements outlined in ERISA Section 206(d)(3)(C)(i)-(iv), as well as in IRC Section 414(p)(2)(A)-(D), QDROs must include certain information in order to become “qualified” — i.e., applicable to actually split an ERISA plan, including the following:
- Name and last known mailing address for the plan participant and the alternate payee
- Name of each plan to which the order applies
- Dollar amount or percentage of benefits to be paid to the alternate payee, or a description of how such amounts should be calculated — i.e., 50% of the account balance as of a certain specified date
- Time period or number of payments to which the order applies
ERISA and the Internal Revenue Code further outline provisions that are not allowed as part of a QDRO. Such prohibited provisions include those that would require the plan to:
- Provide the alternate payee with a benefit not otherwise available under the plan
- Increase the actuarial value of plan-provided benefits
- Pay an alternate payee benefits that have previously been awarded to another alternate payee via an earlier QDRO
- Pay a benefit in the form of a Qualified Joint and Survivor Annuity, or QJSA, over the lives of the alternate payee and their potential future new spouse
Once a DRO has been drafted in accordance with the above terms, it can be sent to the plan administrator. On receipt of the DRO the administrator must review the document within a reasonable period of time, and in accordance with its own procedures — which a plan must establish in writing — determine whether the DRO meets the conditions set forth in ERISA and the Internal Revenue Code to be deemed “qualified.” Notably, the plan administrator’s blessing that the DRO meets the guidelines set forth in federal law ultimately turns the DRO into a QDRO.
It’s important to note that while all QDROs must meet certain requirements as well as share some commonalities, a significant amount of flexibility remains in how such documents can be drafted. When determining how defined benefit pension plan assets will be split, one critical decision is whether the QDRO should be drafted using language that creates a shared payment or a separate interest.
In situations where the shared payment method is used, the alternate payee is just entitled to a portion of the benefits that would otherwise be paid to the participant — e.g., the alternate payee shall receive 50% of all benefits paid by the plan, or the alternate payee shall receive $500 per month of what would otherwise be the participant’s benefit once payment under the plan begins.
Notably, the shared payment QDRO does not affect whose life on which the pension is actuarially based. It follows then, that when defined benefit plan assets are split using the shared payment method, the benefits paid to both the original participant and the alternate payee begin when that original participant retires and starts to collect benefits — or at the time the QDRO is finalized by the plan administrator if the participant has already started receiving benefits.
Conceptually, one might think of QDROs using the shared payment method as a “Who?” type of QDRO, in the sense that its primary function is only to determine who will receive benefits from the plan on whatever payout schedule and terms applied. From the plan’s perspective, however, the “How?” — e.g., timing and calculated benefit payments — doesn’t change. Everything continues to revolve around the participant.
That means there are no actuarial adjustments in the participant’s balance. He or she retains total control and continues to select the form of the benefit to be paid, be it a life annuity, joint and survivor annuity, or lump-sum benefit — though in certain circumstances a QDRO may obligate the participant to select a certain option.
Accordingly, it’s only when payments to the participant have begun that the shared payment QDRO really takes effect and provides a benefit for the alternate payee. And in a sense, the shared payment QDRO is simply turned into a gatekeeper responsible for ensuring that the alternate payee actually receives the amount to which they are entitled and that the tax liability of such payments is properly reported to the alternate payee.
Simply put, the QDRO ensures that the right individuals receive their portions of the regularly calculated benefit amount.
The median age at which couples divorce has steadily risen over the past several decades, yet in 2015 the median age for a first divorce for men was roughly 41 and roughly 40 for women.
Thus, in the overwhelming majority of instances, couples divorce long before payments from a defined benefit plan would begin.
While that may be the case for most couples, there are certainly situations where divorce occurs after pension benefits begin. Such situations may become more common over the next few decades if the recent trend of increasing average ages for divorce persists. Even though divorce rates for younger couples have steadily declined since 1990, a Pew Research study shows that over the same time period, divorce rates for individuals 50 and over have more than doubled.
In these so-called grey divorces it is more likely that pension benefits have already started at the time the divorce is finalized. In such situations the form of benefit — e.g., life annuity, joint life annuity, etc. — has already been irrevocably selected. Thus, the only way to provide an alternate payee directly with benefits that the participant has already started receiving from the plan is to split the amount already being received via a shared payment QDRO.
Example No. 1: Tim and Samantha, both 62, are married. Tim retired at 57 from the local police department, having completed 35 years of service. He was eligible to begin receiving pension benefits immediately, and chose to do so in the form of a life-only annuity with monthly payments of $5,000.
Unfortunately, in the initial years of retirement Tim and Samantha find that they’ve grown apart. As such, they have recently decided to seek a divorce.
As determined by the divorce proceedings, Samantha will receive some of the benefit from Tim’s pension, but Tim has already begun receiving benefits as a life-only annuity — a decision that is irrevocable — which means from the plan’s perspective the “how” component is locked in. Consequently, payments of $5,000, based on Tim’s actuarial life expectancy, will be distributed from the plan monthly until Tim’s death.
Since Tim has already started receiving payments, the divorce decree calls for a shared payment QDRO, which provides the only way Samantha can receive any benefit from the plan. Beginning immediately, it awards Samantha 50% of the benefits paid under the plan, and Samantha starts receiving $2,500 monthly payments.
RISKING INDEFINITE LIMBO
One of the biggest problems with defined benefit plans split with a Shared Payment QDRO is that the ex-spouse alternate payee is largely at the mercy of the participant as to when — and in some cases, even if — benefits from the plan will be received. That’s because benefits to the ex-spouse alternate payee can’t begin until the participant begins to receive their benefits under the plan.
This can become both a major source of future conflict as well as a planning challenge for the alternate payee. Such an individual may want to retire sooner than the participant, but what if a 50-year-old participant really likes their job and doesn’t intend to retire until they’re 80?
That would mean the alternate payee would also have to wait until such time to receive a benefit under the plan. In the same vein, what if the participant has already retired but wants to delay the distribution of benefits under their pension plan to allow their monthly benefit to grow — especially if they know they have to make up for part of it going to someone else? That would leave the alternate payee just stuck and waiting.
Example No. 2: Norman and Christie are each 50 years old, and are in the process of getting divorced. As part of the proceedings a QDRO using the shared payment method has been drafted, which will grant Christie 50% of the benefits accrued to Norman under the plan during their marriage. However, because the QDRO was drafted using the shared payment method, payments to Christie under the plan will not begin until Norman elects to begin receiving benefits.
Fast-forward 15 years and Norman, now 65, is still working for the employer sponsoring the defined benefit plan that was split via the QDRO. He doesn’t give retirement much thought, and when asked about it, says he still thinks he has at least another 10 or so good years in him. As such Norman doesn’t plan on receive any pension benefits for about another decade, at which point he and Christie will be 75.
Christie, on the other hand, has had enough. She no longer enjoys work and would like to retire to spend more time with her children and grandchildren. The problem is that Christie can only afford to make the leap into retirement if she has that additional income from her portion of Norman’s pension benefits. That won’t begin anytime soon because Christie can’t control the start of Norman’s pension payments and Norman doesn’t plan to start them himself in the near term.
Clearly, this might cause some tension. Imagine how Christie would feel knowing that her ability to retire rested in the palm of another person: her ex-husband.
From a planning perspective for the alternate payee, things aren’t much better. In fact, the best-case scenario for Christie might be remaining on good-enough terms with Norman so that she can ask him about his own retirement plans and receive a genuine answer. Given Norman’s plans, she may not like his answer, but at least she’d be able to plan accordingly.
Unfortunately though, for some couples the trauma of a divorce produces so much resentment that having such a conversation would be next to impossible. In such situations, retirement planning can be even more challenging than normal thanks to the ambiguous nature of the start date of the pension benefits.
But it can get even worse.
TERMINATION OF BENEFITS
Not only is the ex-spouse alternate payee potentially left waiting for the participant to begin receiving benefits, there is also the risk that after finally beginning to receive them, the participant dies before the alternate payee. Unless a joint-survivorship annuity option is elected, this could terminate the alternate payee’s benefit quite unexpectedly.
Indeed, absent a joint-survivorship election, the fear alone of even potentially losing all future plan benefits might force an alternate payee to reduce their standard of living — by lowering expenses — in an effort to save more should that possibility materialize.
And in some situations, the alternate payee may be entirely reliant on the participant outliving them to make it through retirement. In the worst of circumstances this can lead to a very unfortunate outcome for the alternate payee.
Example No. 3: Recall that as part of her divorce from Tim, Samantha was awarded 50% of the $5,000 monthly benefit paid by Tim’s defined benefit plan as a life-only annuity. Thus, she received $2,500 per month and would continue to do so until Tim’s death.
That $2,500 monthly amount, plus Samantha’s Social Security benefit, are enough for her to enjoy retirement and remain in the home in which she’s lived for the past 40 years. Without the pension money, however, she would have to make major changes to her lifestyle, including a change in residence.
A few years after their divorce was finalized, when Samantha is 70 years old, Tim dies unexpectedly of a heart attack, and Samantha suddenly loses her monthly benefit from Tim’s pension. Samantha now finds herself in a difficult situation with few options.
Had Tim elected a joint survivorship annuity option, the monthly benefit would have been reduced, but Samantha would still have been guaranteed pension payments for her life as well, and may have had fewer concerns.
Tim, however, chose to receive benefits from the plan as a life-only annuity, and the fact that Samantha was subsequently awarded half of the amount paid by the plan did not, in any way, change that election. Thus, once Tim was gone, so too were Samantha’s monthly pension checks.
So if a shared payment QDRO is drafted to split not-yet-started pension benefits, the alternate payee should almost always ensure that language is included within the QDRO document requiring the participant to elect at least some form of a joint annuity. This way, if the participant predeceases the alternate payee after benefits begin, the alternate payee will continue to receive benefits for the balance of their own life.
While this may work from the alternate payee’s perspective, it’s not likely to sit very well with the participant. Consider that the shared payment QDRO is already going to be cutting the participant’s pension benefits down. Electing to take a joint life option for pension payments — or being required to do so — will further reduce the starting amount of the payment, which was reduced from the split in accordance with the QDRO to begin with.
It’s easy to imagine how a substantial pension could quickly be whittled down to an amount that is no longer enough to support the participant’s retirement goals. In such situations, the participant spouse may resist using a QDRO that required them to elect a joint-survivorship pension option.
The strong desire of a participant to have a pension based only on their own life expectancy is bolstered by the fact that, in general shared payment QDROs are drafted in such a way that if the alternate payee predeceases the participant, the benefits that were being paid to the alternate payee revert back to the participant — though it’s possible to require such amounts to be paid to the alternate payee’s estate. Thus, such amounts become a veritable windfall for the participant and, at least in their own mind, often makes them feel as though their benefit is whole again.
SHORT LIFE EXPECTANCY
A possible — albeit limited — exception to the desire of an alternate payee to force the participant to elect a joint annuity form of benefit exists when the alternate payee is in poor health and/or is otherwise highly likely to predecease the participant. In such cases the alternate payee and the participant may both want the participant to select a life-only annuity.
In this way gross payments from the plan are as high as possible, allowing the participant and alternate payee each to receive the biggest possible benefit. And if the alternate payee is confident that they will be the first to die, there is minimal value in requiring the participant to elect a joint pension that would lower their monthly benefit as well.
Example No. 4: Felix and Rochelle, both 63, are in the process of getting divorced. Felix, who expects to retire and begin collecting pension benefits in two years, is a participant in a defined benefit plan. He is in excellent health and both of his parents, who are in their mid-80s, are also in excellent health.
Rochelle, on the other hand, has been diagnosed with a terminal illness and has been given five to six years to live.
Given the circumstances Rochelle would likely benefit from having Felix elect a life-only annuity as a form of benefit once he retires. The life-only annuity will produce the largest possible payment from the plan, which in turn will make Rochelle’s share of that payment as large as possible. And while those payments will cease when Felix dies — even if that happens to be before Rochelle dies — the overwhelming likelihood of him outliving Rochelle in this situation may make that a palatable risk.
Couples may divorce years — and in some cases, decades — before any benefits are ever paid out from the pension plan. What happens though, if the participant dies after a divorce and shared payment QDRO are finalized, but before benefits from the plan are distributed?
The short answer? In many cases it can mean the alternate payee will never receive any benefits from the plan. That’s because, again, the payments for the alternate payee are tied to the original participant, and if the latter dies without triggering benefits, then there are no benefits triggered to be paid. This can result in a potentially lower standard of living for the alternate payee.
The only way to solve this problem under a shared payment QDRO, and to ensure that the alternate payee won’t completely lose out on benefits if the participant predeceases the commencement of payments from the plan in the first place, is to make sure that the shared payment QDRO includes some very specific language. More precisely, the QDRO must designate the alternate payee as the surviving spouse for purposes of the qualified pre-retirement survivor annuity, or QPSA, which is required to be offered by all qualified plans.
Example No. 5: Alexandra and Paul, both 50, are in the process of getting divorced. Alexandra is a participant in a defined benefit plan, but has not yet begun to receive benefits.
Alexandra is in excellent health and is likely to outlive Paul, who has a number of health issues, by a substantial number of years. Nevertheless Paul has a knowledgeable QDRO preparer who is not taking any chances. As such he drafts the QDRO with language requiring Alexandra to designate Paul as her spouse for purposes of a QPSA.
Sadly, Alexandra is involved in a car crash shortly after the divorce and dies. Thanks to the QPSA requirement drafted into Paul’s QDRO, he will still be able to receive benefits from Alexandra’s plan, even though Alexandra had not yet begun to receive any benefits. If, however, the QPSA language had been omitted from the document, Paul would not have received anything.
REDUCING POTENTIAL CONFLICT
There has to be a better way, right? Thankfully, as long as payments from the pension plan have not already begun — in which case, as noted earlier, a shared payment QDRO must be used — the pension plan can be split via a QDRO that uses the so-called separate interest method.
In essence the separate interest QDRO takes the participant’s accrued plan balance and divides it into two separate and distinct accounts: one that belongs to the participant and one that belongs to the alternate payee. The latter gets their own separate account that is then actuarially adjusted, for the amount assigned, to account for their life expectancy.
More simply, it turns the alternate payee into another participant themselves, which means that when the separate interest QDRO is executed, both the participant and the alternate payee are given control over their own share of the plan benefits, along with the ability to make decisions in their own best interest — specifically with respect to when and how payments will be made in the future.
The decisions made by the participant and alternate payee also have no impact on one another. The alternate payee could decide to begin receiving benefits earlier or later than the participant. Similarly, the participant might get remarried and decide to have their benefits paid as a joint and survivor annuity over their own lifetime as well as that of their new spouse, all while the alternate payee elects to receive his/her portion of the benefits as a single life annuity in order to receive the maximum monthly payment.
Thus, in contrast to a shared payment QDRO, a separate interest QDRO changes both who is going to receive benefits from the plan, while also allowing both the participant and the alternate payee to decide how they want to receive those benefits.
Example No. 5: Erin and Victor are in the process of getting divorced. Victor is 60 years old and would like to retire in two years. Erin is 58 years old and plans to retire at 65.
Currently, Victor’s pension benefit is estimated at $5,000 per month if he takes it as a single life annuity at age 62. Suppose that as part of their divorce proceedings, Erin is awarded half of Victor’s pension benefit via a separate interest QDRO. As a result Victor’s estimated pension benefit — as a life annuity to begin in two years — will be reduced by 50% to $2,500.
Erin, on the other hand, would not receive $2,500 as a monthly benefit if she decided to take a life annuity in two years. That’s because, on receiving her share of Victor’s pension, the benefit would be actuarially adjusted downward to account for her younger age. So if she did elect to begin receiving benefits as a life annuity at that time, she might only receive $2,320 per month instead.
The beauty of the separate interest QDRO is that Erin and Victor’s benefits are no longer intertwined. Thus, Victor can retire at 62 and collect his $2,500 life-only annuity monthly benefit as planned. Erin, on the other hand, can wait until she is 65 and retires to begin receiving her portion of the pension benefits. And by that time, her monthly life-only payments may have grown to $2,650 — even higher than Victor’s own monthly benefit.
NO BENEFIT INCREASE
QDROs using the separate interest method are generally more workable and palatable options when it comes to splitting defined benefit plans — as well as for some defined contribution plans for that matter.
QDROs using the separate interest method are generally more workable and palatable options when it comes to splitting defined benefit plans
That said, when a spouse dies, the surviving individual will not see any increase in their ongoing benefits. Thus, participants often prefer the shared payment QDRO because there is a possibility, depending on the precise way in which the QDRO is drafted, that the participant may see a significant increase in their ongoing benefits if the alternate payee dies first. This is due to the alternate payee’s payments being shifted back to them. And this increase can be meaningful, especially if there is a substantial difference in the ultimate longevity of the ex-spouses.
For many individuals the decision to seek a divorce is only reached after painstaking evaluation, often over many years. But once the decision has been made, the process has only just begun — and it’s not an easy process in even the most amicable of situations.
With pure assets the two spouses can mostly go their own way, and make decisions for themselves. That is not so easy when dividing defined benefit plans.
For that reason, whenever possible the separate interest method of splitting a defined benefit plan is generally favored. This way each ex-spouse can truly have their own portion of the pension and can make decisions without regard to how it will impact the other. If only in this limited regard couples can take a critical step toward closure, and accompany their legal divorce with a financial one.