Identification and Valuation of Retirement Plans

Transcription

1 Identificatin and Valuatin f Retirement Plans By Drthy A. Vigt dvigt@sdflaw.cm Article riginally appeared in the September 2010 Issue f Kane Cunty Bar Assciatin Bar Briefs What des a divrce attrney need t knw abut retirement plans t settle r try a case? This article is nt intended t make yu an Emplyee Retirement Incme Security Act f 1974 (ERISA) expert, but t familiarize yu with basic infrmatin regarding retirement plans. It is acknwledged that the majr assets that are divided when parties divrce are the retirement plans and the marital residence. Despite the recent ecnmic dwnturn, a substantial prtin f many marital estates can still be fund in retirement benefits. Cnsidering that the value f real estate has als drpped, retirement benefits may be the main asset still available t divide when there is a divrce. A cuple may have a number f different retirement plans t divide up when they divrce. The State f Illinis recgnizes that retirement benefits f all srts are marital assets that are subject t divisin between spuses 1. In rder t effectively value and divide up the retirement benefits, it is imprtant t understand the differences between the varius types f plans. There are tw main categries f retirement plans cntrlled by ERISA law: 1) Defined Cntributin Plans and 2) Defined Benefit Plans. The plans perate in substantially different ways. It is imprtant t understand the differences between the types f plans and hw thse differences affect the valuatin f the retirement plans. Other surces f retirement plans are thse spnsred by gvernment entities and supplemental plans. Defined Cntributin Plans: A defined cntributin plan fcuses n the cntributins t the plan. A defined cntributin plan maintains an individual accunt with a balance that can be determined fr each participant 2. The accunt balance will be derived frm emplyee r emplyer cntributins and frfeitures 3, and market gains and lsses n same. The defined cntributin plan will nt prmise a specific benefit amunt at retirement. The Participant receives the balance in their accunt at retirement (r ther triggering factr). Features f Defined Cntributin Plans: a) The emplyee has an individual accunt and can cntrl the investments within that accunt. b) The emplyee assumes the investment risk. c) The funds in the accunt are tax deferred. d) The accrued benefit is the accunt balance which may include frfeitures and emplyer matches. 1 In re Marriage f Hunt, 78 Ill.App.3d 653, 397 N.E.2d 511 (1 st Dist., 1 st Div. 1979); In re Marriage f Uluhgian, 86 Ill.App.3d 654; 408 N.E. 2d 107 (5 th Dist. 1980); In re Marriage f Pieper, 79 Ill.App.3d 835, 398 N.E. 2d 868 (1 st Dist., 4 th Div. 1979); In re Marriage f Hackett, 113 Ill.2d 286, 497 N.E. 2d 1152 (1986). 2 An emplyee wh acquires benefits in a retirement plan is called the participant. Fr the types f plans discussed herein, the way that an emplyee acquires benefits if thrugh emplyment. Hw lng the persn needs t wrk t qualify fr benefits may differ depending upn the type f the plan. 3 Frfeitures ccur when an emplyee leaves the emply befre becming 100% vested r if the emplyee cannt be lcated. Funds that are frfeited are reallcated t ther participants r used t defray plan csts. 26 USCA 411(a)(3)

2 e) The amunt f the emplyer cntributins may either be discretinary r mandatry. f) The value f the plan is the sum n the participant s accunt statement. g) Vesting may be immediate r ver a 6 year perid (r shrter perid). 4 h) Because the investment risk is n the plan participant, a defined cntributin plan is nt cvered by the Pensin Benefit Guaranty Crpratin ( PBGC ). Defined cntributin plans have becme mre ppular with emplyers because all the investment risk is shifted t the emplyee. These plans als have lwer administrative csts than defined benefit plans. The fllwing are several variatins f defined cntributin plans: 5 1) Prfit Sharing Plans 2) Stck Bnus Plans 3) Mney Purchase Pensin Plans 4) Emplyee Stck Ownership Plans (ESOPs) 5) Target Benefit Plans 6) 401(k) Plans 7) Simplified Emplyee Pensins (SEPs) 8) 403(b) Plans 9) 457 Plans It is pssible that a defined cntributin plan may cntain the features f ne r mre f these types f plans, such as a Prfit Sharing and 401(K) Plan. The differences between the types f defined cntributin plans are listed belw. 1. Prfit Sharing Plans 6 : The cmpany makes discretinary, substantial and recurring cntributins which may r may nt be related t prfits. Actual prfits are nt necessary. The plan has a frmula fr dividing the emplyer cntributin amngst the participants. N emplyee cntributins are permitted. Lans and in-service distributins may be made (subject t the 10% additinal tax if withdrawn befre age 59½). The cntributin limit is the lesser f 25% f cmpensatin r $49,000 in 2009 and Stck Bnus Plans 7 : Same features as in prfit sharing plans as nted abve except that cntributins t the plan are in stck, rather than cash frm. Benefits frm the plan may be distributed in the frm f stck r in cash. The participant has a right t take their distributin in cash. 3. Mney Purchase Pensin Plans 8 : The emplyer cntributin t this plan is required and is nt discretinary. The cmpany s cntributins are based n a specific frmula that generally incrprates the participant s salary (e.g.: 2% f cmpensatin). Bth emplyer and emplyees may cntribute t the plan. Lans may be permitted, but in-service distributins are nt. The cntributin limit is the lesser f 25% f cmpensatin r $49,000 in 2009 and Emplyee Stck Ownership Plans (ESOPs) 9 : 4 26 USCA 411(a)(2)(B). 5 Mre infrmatin n retirement plan criteria can be fund at the Internal Revenue Service website at r at the Department f Labr website at USCA 401(a)(27); Treas. Reg (b)(1)(i) and (ii) 7 26 USCA 401(a)(23) 8 Treas. Reg (b)(1)(i)

3 May be designed t lk mre like a prfit sharing plan r a mney purchase plan, hwever, the plan must primarily be invested in cmpany stck. The participant can take their distributin in cash, just like a Stck Bnus Plan. 5. Target Benefit Plans 10 : This is a mney purchase pensin plan under which cntributins t an emplyee s accunt are determined by reference t the amunts necessary t fund the emplyee s stated target benefit at retirement. The plan fcuses n paying a certain benefit amunt t the participant at retirement which is similar t the way a benefit under a defined benefit plan is expressed. The actual benefit paid is the accunt balance which will likely vary frm the target benefit based n investment perfrmance 11. Bth emplyer and emplyees may cntribute t the plan. Lans may be permitted, but in-service distributins are nt. The cntributin limit is the lesser f 25% f cmpensatin r $49,000 in 2009 and (k) Plans 12 : This plan is a cash r deferred arrangement. The plan allws emplyees t elect t defer a specified prtin f their salary as an emplyer cntributin t the plan. The sums deferred under these plans are excluded frm the emplyee s taxable incme. The emplyer als cntributes t the plan per a frmula (e.g.: match 50% f emplyee cntributins up t X% f cmpensatin). The emplyee is always 100% vested in wn cntributins. The emplyer cntributins may be subject t a vesting schedule. Lans and in-service distributins are permitted (subject t the 10% additinal tax if withdrawn befre age 59½). The emplyee cntributin limit is $16,500 fr 2009 and An emplyee ver 50 can make a catch-up cntributin up t $5,500. The verall cntributin limit between the emplyer and emplyee is the lesser f 25% f cmpensatin r $49,000 in 2009 and Simplified Emplyee Pensins (SEPs): May be adpted by a business f any size, even a self-emplyed persn. The SEP allws emplyers t make cntributins n a tax-favred basis t individual retirement accunts (IRAs) wned by the emplyees subject t certain limits. An emplyee must set up the IRA t accept the emplyer cntributins. A SEP is funded slely by emplyer cntributins. The emplyee is always 100% vested in the mney in the SEP-IRA. The verall cntributin limit between the emplyer and emplyee is the lesser f 25% f cmpensatin r $49,000 in 2009 and The Participant can withdraw cntributins and earnings at any time (subject t the 10% additinal tax if withdrawn befre age 59½) (b) Plans 13 : Als knwn as a tax-sheltered annuity (TSA) plan, is a retirement plan fr certain emplyees f public schls, emplyees f certain tax-exempt rganizatins, and certain ministers USCA 4975(e)(7); 26 USCA 401(a)(28) 10 Treas. Reg (b)(1)(i) 11 Rev. Ruling , C.B USCA 401(k) USCA 403(b)

4 Individual accunts in a 403(b) plan can be: 1) An annuity cntract, which is a cntract prvided thrugh an insurance cmpany, 2) A custdial accunt, which is an accunt invested in mutual funds, r 3) A retirement incme accunt set up fr church emplyees. Just like in a 401(k) plan, a 403(b) plan allws the emplyee t defer salary t the plan. Lans and in-service distributins are permitted (subject t the 10% additinal tax if withdrawn befre age 59½). The emplyee cntributin limit is $16,500 fr 2009 and An emplyee ver 50 can make a catch-up cntributin up t $5,500. The verall cntributin limit between the emplyer and emplyee is the lesser f 25% f cmpensatin r $49,000 in 2009 and (b) Plans 14 : Salary deferral plans set up by a state r lcal gvernment r a tax-exempt rganizatin under IRC 501(c). These plans share many f the same features as 401(k) and 403(b) plans. Lans may nt be available. Valuatin f Defined Cntributin Plans: All defined cntributin plans have an individual accunt balance fr the participant. If yu have a defined cntributin plan, the value f the plan is easy t determine. The value is the amunt cntributed t the plan plus any earnings grwth r lss. The value f a defined cntributin plans is the amunt n the mst recent statement. Defined Benefit Plans: A defined benefit plan fcuses n benefit r the sum the emplyee will be paid at retirement. A traditinal defined benefit plan pays the emplyee a guaranteed payment each mnth in the frm f an annuity until the emplyee dies. Many Unin plans are defined benefit plans (but nt all!). Features f Defined Benefit Plans: a) The emplyee des nt have an individual accunt. b) The emplyee cannt cntrl the investment f their retirement funds. c) The emplyer assumes the investment risk. d) The accrued benefit is based upn a definite and pre-determined frmula t calculate the ultimate benefit payable t the participant (e.g.: 2% f final highest pay x number f years emplyed (up t 30)). e) The cntributins are mandatry and may nt be cntingent n prfits. f) The plan must use the services f a actuary t calculate the apprpriate emplyer cntributins necessary t fund the plan s benefit frmula. g) The benefits are subject t the systemic payment f benefits rule, thus annuity frms must be available as a frm f payment. Jint and life annuities must autmatically be prvided if the participant is married 15. h) Mst plans d nt permit lans. i) Vesting may be immediate r ver a 7 year perid (r shrter perid) 16. j) The plan may nt pay a benefit mre than $195,000 per year in 2010 (sum adjusted by inflatin) 17 k) The plan is cvered by the Pensin Benefit Guaranty Crpratin ( PBGC ). If the plan is unable t pay the benefits [example: United Airlines bankruptcy], the PBGC will assume respnsibility fr paying sme prtin f the benefits due USCA USCA 401(a)(11) USCA 411(a)(2)(A) USCA 414(b)(1) USCA 1301 et.seq

5 A defined benefit plan requires an actuary t determine the amunt f the emplyer s cntributin t the plan each year. The assumptins the actuary and emplyer must cnsider when funding such a plan are: a) The emplyee participant s current and prjected cmpensatin; b) The mrtality f the emplyee / participant and beneficiaries; c) The amunt f emplyee turnver / attritin; d) The number f emplyees whm are married r fr whm a frm f a jint and survivr benefit may be paid; e) The expected time f payment (early retirement, late retirement, etc.); and f) The interest rate earned n the investments in the trust fund. The Actuary then calculates a number based upn all the abve factrs and reduces it t a present cash value which is the plan s annual cntributin. This number is an educated estimate and can easily vary between tw different actuaries depending upn the factrs they use. The risk f funding a defined benefit plan is the emplyer s. The emplyee is guaranteed the benefit, the emplyer hpefully has calculated all abve crrectly t prvide adequate funding fr the plan t prvide the benefit. Hwever, due t increasing lngevity and the tanking f the market, many plans are currently under-funded based upn the benefits they have prmised t pay. The fllwing are several different types f defined benefit plans: 1) Fixed Benefit 19 ; 2) Flat Benefit 20 ; 3) Unit Benefit 21 and 4) Variable r Equity type 22 5) Cash Balance Plan. The nly difference between the abve types f defined benefit plans listed in 1-4 is in the benefit frmula used. The Cash Balance Plan is structured differently than all f the ther frms f defined benefit plans. Cash Balance Plan 23 A Cash Balance Plan is a hybrid style plan. It is designed t lk mre like a defined cntributin plan because it prvides an emplyee with a hypthetical accunt balance rather than a benefit based n a frmula which is generally paid mnthly ver life. The Cash Balance accunt is credited with: a) pay credit frm salary and b) interest credit defined by the plan. The risk is cmpletely n the emplyer t fund the accunt. Increases and decreases in value f the plan s investments d nt directly affect the participant s benefit. The plan guarantees the benefit and interest credit. Mst cash balance plans are cnversins frm traditinal defined benefit plans. 19 Fixed Benefit is a plan frmula that prvides a participant with a fixed percentage f cmpensatin at retirement. The years f service are nt part f the calculatin, hwever, the plan may require a certain number f years f service t qualify fr the benefit. If the plan pays 30% f cmpensatin at retirement, the benefits prvided wuld be the same whether a persn wrks 10 years r 40 years. 20 Flat Benefit is a plan frmula that pays a specified amunt at retirement regardless f salary r years f service. Such frmula rewards neither senirity r cmpensatin level. 21 Unit Benefit is a plan frmula that credits a participant with a certain unit f pensin fr each year f credited service. This frmula may prvide fr a certain percentage f cmpensatin times number f years. 22 Variable r Equity type is any f the abve frmulas but nce the frmula is determined the benefit is adjusted peridically after retirement fr the cst f living index USCA 401; 26 USCA 411; 29 USCA 1113; Revenue Ruling , Public Law

6 The Cash Balance Plan lks like a defined cntributin plan because the participant has an accunt balance. Hwever, like a defined benefit plan, the participant des nt actually have a separate accunt within the plan; all funds t pay benefits are intermingled. The cash balance plan is like a defined benefit plan because the emplyer is the nly ne making cntributins t the emplyees accunt. A defined cntributin plan may allw the emplyee t cntribute t their accunt. The Cash Balance Plan, like any ther defined benefit plan des nt allw the emplyee t cntrl the investment f the funds. In a Cash Balance Plan, the emplyer cntrls the investment. A Cash Balance Plan is als cvered by the PBGC, whereas a defined cntributin plan is nt. Valuatin f Defined Benefit Plans: If yu have a defined benefit plan, the value is a prjected amunt at retirement based upn the plan frmula. A defined benefit plan may prvide a benefit estimate. The defined benefit plan statement will prvide that the benefit at age 65 (r anther age) is X dllars a mnth. T determine a cash value frm that estimate, yu need an actuary t calculate the present cash value frm the benefit that the plan estimates t pay at retirement. Other Retirement Plans: There are a number f ther fairly cmmn surces fr retirement benefits and they are: 1) Supplemental Plans and 2) Gvernment Plans. It is imprtant t understand hw these plans wrk as well befre attempting t divide them in divrce. Supplemental Plans 24 : Many cmpanies ffer a supplemental pensin prgrams fr certain executives. These plans may be either defined cntributin r defined benefit style plan and may be called a Supplemental Executive Retirement Plan (SERP), Tp Hat Plans, Nn-Qualified Plans r Surplus plans r ther variatins. The purpse f these plans is t prvide highly paid persns with retirement benefits abve the IRS limitatins. After all if yu make a $1,000,000 a year, the maximum payut f $195,000 per year frm the defined benefit plan at retirement wuld nt begin t cmpensate fr r replace yur wrking incme. Thus, fr such executives, an emplyer may prvide a supplemental plan. The value f a supplemental plan depends n whether it is based n a defined cntributin plan mdel r a defined benefit plan mdel. What is imprtant fr a divrce practitiner t find ut abut a supplemental plan, in additin t the value f the plan, is whether r nt the plan will accept a Qualified Dmestic Relatins Order ( QDRO ). Nt all plans accept QDROs and if the plan des nt accept a QDRO, then the verall prperty divisin strategy may need t be revised. The strategy may invlve prviding the nn-participant with additinal ther assets (if there are any) t cmpensate fr the value f the supplemental plan, r making the Participant the cnstructive trustee f a prtin f the benefits cmprising the Alternate Payee s share f the supplemental plan if, as and when, such benefits are received by the Participant. Gvernment Plans: In additin t the private sectr defined cntributin and defined benefit plans, there are many gvernment retirement plans that are divisible in divrce. Gvernment pensin systems are cntrlled by relevant statutry authrity and nt by ERISA. The statute will dictate the apprpriate methd f dividing the pensin plan. Sme examples f gvernment pensin plans are the: State Emplyees Retirement System f Illinis, Judges Retirement System, Municipal Emplyees Annuity and Benefit Fund f Chicag, Teachers Retirement System, Pliceman s Annuity Fund, USCA 409A

7 Firefighters Pensin Fund, TIAA / CREF, Military Retirement Plans, Federal Emplyees Retirement System, and Civil Service Emplyees Retirement System. A gvernment plan may prvide benefits in a number f ways. If the plan is mre like a defined cntributin plan, then the value n the statement is accurate. Hwever, many gvernment plans are mre like defined benefit plans. One f the differences is that the emplyee and the emplyer / gvernment bth cntribute twards the benefits. The statement may prvide a sum fr the value f the emplyee s cntributins, and a final estimated mnthly annuity amunt fr the benefit as well. The sums will be very different because bth the gvernment and the emplyee are cntributing twards the final amunt f the benefit. Fr example, a statement may shw that the emplyee s cntributins are $150,000, but that the final benefit is $5000 a mnth fr life. Based upn cntributins alne, if paid $5000 a mnth, the emplyee wuld exhaust the retirement funds they paid int the system in 30 mnths. The plan pays $5000 a mnth fr life, s the value f the benefit far exceeds the sums cntributed by the emplyee. Be sure that yu knw what the benefit is that the participant will be paid. This type f plan may require an actuary t prepare an present cash value as well. Plan Identificatin: Since there are s many different types f retirement plans, hw des ne determine what type f plan the clients have? The mst cmmn methd is t ask fr cpies f retirement plan statements r benefit estimates. It may r may nt be bvius frm the statement r benefit estimate what type f plan yu have. If yu can determine the infrmatin frm the statement, yu may nt want t investigate further. If yu cannt determine what type f plan yu have frm the statement, then hpefully the statement at least prvides the Plan Administratr s cntact infrmatin. Yu can then cntact the Plan Administratr and ask fr the: Summary Plan Descriptin Plan Dcument Mdel QDRO 25 and QDRO (QILDRO) Prcedures. Usually a review f the Summary Plan Descriptin will tell yu what type f plan yu are dealing with. If nt, then the Plan Dcument may have t be reviewed t figure this ut. The Mdel QDRO prvided may als tell yu what type f plan yu are dealing with. If in dubt, cntact the Plan Administratr and ask. Once yu knw what type f plan yu have, and have determined the value f the participant s benefits, yu can then prceed t divide the retirement benefits between the parties. Plan Divisin: Let s lk at a hypthetical negtiatin abut retirement benefits. The parties are bth age 50 upn divrce. The wife has a Defined Cntributin 401(k) Plan with a balance f $80,000. The husband has a Defined Benefit Plan with an accrued benefit f $80,000. All benefits are marital. It wuld appear their benefits are equal. If each keeps their wn benefit, it wuld simplify the divrce because n additinal paperwrk wuld need t be prepared t divide the retirement benefits. Hwever, the husband s benefit plan statement shws that the sum he currently has accrued will pay a benefit t him f $2000 a mnth at age 65 fr the rest f his life. This calculates ut t $24,000 a year. 25 QILDRO = Qualified Illinis Dmestic Relatins Orders which are used fr many Illinis gvernment plans

8 He wuld receive a ttal f $80,000 in benefits ver the curse f 40 mnths (3 years & 4 mnths). If he lives 10 years, the value f his benefit is $240,000. In the meantime, the $80,000 in the wife s 401(k) accunt will increase r decrease depending upn market fluctuatins. If she manages a cmpunded grwth rate f 3% ver 15 years, the ttal value f her accunt wuld be apprximately $125,000 when she reaches age 65. Once the funds in the accunt are exhausted, that is it, her benefits run ut. Therefre, if each party keeps their wn benefits, the husband wuld end up with a much larger benefit than the wife frm benefits that appeared t be equal. If the gal is fr each party t receive half f the retirement benefits earned at the divrce, that gal wuld nt be reached by each party keeping their wn benefits. If the parties were t split the benefits 50/50, then the husband wuld receive $40,000 frm the wife nw (that he can put int an IRA) and in exchange the wife wuld receive the right t btain $1000 a mnth fr life at age 65. It wuld well be wrth the investment f $40,000 nw t btain $120,000 ver the curse f 10 years in the future (r mre if she lives lnger). The parties wuld have t prepare Qualified Dmestic Relatins Orders ( QDRO ) t split the benefits and give their ex-spuse an interest in their respective plans. Let s vary the scenari a bit. The parties are still bth age 50 upn divrce. Wife has the same Defined Cntributin 401(k) Plan with a balance f $40,000. Husband has the same Defined Benefit Plan with an accrued benefit f $80,000. The Husband prpsed prviding $20,000 t the wife s that each has benefits wrth $60,000. Hwever, the Husband s plan will nt allw him t remve funds at this time. S instead, t equalize the retirement benefits, the Husband gives the wife an additinal $20,000 frm anther asset. The Husband s plan is still wrth the sum f $2000 a mnth t him at retirement. The wife will have $60,000 which again with a cmpunded grwth rate f 3% ver 15 years will be wrth apprximately $94,000. The equalizatin f benefits thrugh an exchange f assets als wuld nt prvide the wife with a benefit equal t the husband s. The reasn the result f a apparently equal benefit exchange is s different is because we are cmparing apples t ranges. There are substantial differences between a defined cntributin plan and a defined benefit plan. The accrued benefit in a defined benefit plan is nt the value f the plan, whereas the value f the 401(k) plan is the statement balance 26. Therefre, befre yu agree t settle yur case, be sure that yu knw exactly what the benefits yu are dealing with are wrth. Cnclusin: Be aware that defined cntributin plans, defined benefit plans, supplemental plans and gvernment plans all perate quite differently. In rder t btain an equitable settlement fr yur client, yu need t understand what kind f plan yu have and hw t value it. Knwledge is pwer, s the mre yu knw abut the retirement plans that bth parties have, the better prepared yu are t discuss an apprpriate settlement r be ready fr trial. 26 See In re Marriage f Mantei, 222 Ill.App.3d 933, 583 N.E. 2d 1192, 164 Ill.Dec. 870 (Ill App. 4 Dist., Dec. 19, 1991)