The financial intricacies of a divorce can be confusing, especially when it involves dividing pensions. Understanding how pensions function and the legal frameworks surrounding them is a key part of an equitable agreement.
Understanding Pensions
Pensions are “defined benefit plans”, meaning your employer guarantees a specific payment upon retirement, unlike “defined contribution plans” such as 401(k)s or 403(b)s, where the employee contributes by way of a withholding, and the employer contributes a set matching percentage to your retirement account. Many employers do not offer pensions, which are more common among large employers like the state or federal government, universities, and unions. These plans rely on a continuous influx of contributions from current employees and provide payments to retirees through investment growth.
Key Characteristics of Pensions
- Defined Payments: Pensions promise future payments, often a percentage of the employee’s most recent few years’ salary, typically based on the highest earning years. The percentage depends on the length of participation in the plan, with a longer tenure translating to higher benefits.
- Employer Types: Pensions are prevalent in large organizations due to the need for a substantial base of contributors to sustain the fund. They are less common in smaller businesses.
- Future Projections: Since pensions are tied to future earnings, their exact value can be difficult to predict. Estimates are based on current salary and tenure, but future salary increases can affect the final payout.
Approaching Pensions in a Divorce
When dealing with pensions in a divorce, there are two primary methods: dividing the pension or trading it for other assets. Each approach has its own set of considerations.
- How to Divide the Pension:
- Domestic Relations Orders: The division is executed through a domestic relations order. This order instructs the pension plan on how to allocate the benefits between the employee and the ex-spouse at the time the employee spouse retires or becomes eligible under the terms of the plan.
- Future Payments: The non-employee spouse receives their percentage share of the pension when the employee spouse retires, or becomes eligible to retire under the Plan terms. This approach of dividing the pension in-kind avoids the need for immediate valuation and division of the pension’s worth.
- Calculation: The pension plan will calculate each spouse’s share based on the employee’s salary and tenure at retirement, which means the non-employee spouse’s share could increase if the employee’s salary rises.
- Trading the Pension:
- Valuation: If one spouse prefers to keep the pension, a forensic accountant is hired to determine the present value of the community interest in the pension. This complex calculation considers future years of service by the employee, future payments estimates, and the current amount needed to fund these payments.
- Asset Trade: The calculated value can then be traded for other marital assets. Common trades include other retirement accounts (401(k)s, IRAs) or tangible assets like the marital home or businesses.
- Risk Factors: Trading pensions involves risks, such as the potential underfunding of the pension plan or changes in the employer’s financial stability. It is important to weigh these risks, especially if retirement is still years away.
Considerations for Asset Trading
- Flexibility of Withdrawal:Defined contribution plans like 401(k)s offer more flexibility, as you can choose how much to withdraw upon reaching the eligible age, which can be beneficial for tax planning.
- Emotional Attachment:Some individuals may have a strong attachment to their pension, viewing it as an important part of their financial security.
- Capital Assets:Trading a pension for an asset like a home can be advantageous if the spouse desires stability and continuity in their living situation and is less concerned about income in retirement.
Dividing pensions in a divorce requires careful consideration of future benefits, present value, and personal preferences. Whether opting to divide the pension or trade it for other assets, understanding the complexities and potential risks will help to make informed decisions. Consulting with legal and financial experts, such as forensic accountants, will provide valuable insights and ensure a fair distribution, paving the way for financial stability post-divorce.
Lisa R. Murray is an experienced attorney specializing in Collaborative Divorce and Mediation. She can help you determine your goals for your divorce and post-divorce life. She can be reached by calling 650-642-3897.