5DFA Journal | October – December 2017

COMMON MISTAKES NOT TO MAKE When Dividing Defined Benefit Plans

Steer Clear of These Costly Errors and Get Clients All the Money They’re Owed

Emily McBurney, P.C.

Retirement assets are often the most substantial part of a marital estate, but dividing them up is one area of divorce practice where it is especially easy to make mistakes—and those errors often cannot be fixed once they are discovered.

In this series, we have been exploring some of the most common errors in this area and how to avoid them. In the last issue, we covered "Common Mistakes Dividing Defined Contribution Plans in Divorce." In this issue, we’ll review contribution plans briefly and address how to avoid three defined benefit plans pitfalls.

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COMMON MISTAKE #1Failing to Clarify the Valuation Date

The date of division or valuation is just as important in dividing a defined benefit plan as it is for a defined contribution plan. With defined benefit plans, the issue is not earnings and losses, but rather identifying the cutoff point after which the former spouse is not entitled to benefit accruals based on the employee’s continued service under the retirement plan.

Depending on how much longer the employee spouse will continue to work for the employer and accrue additional benefits, there could be an enormous difference in the result between “Wife shall receive 50% of the Husband’s benefits under the Pension Plan, determined as of the date of divorce,” and “Wife shall receive 50% of the Husband’s accrued benefits under the Pension Plan, determined as of the date of the Husband’s retirement.” Perhaps worst of all would be “Wife shall receive 50% of the Husband’s Pension.”

That lack of specificity pretty much guarantees that there will be a dispute about what this phrase means!

Most defined benefit plans will permit (or even encourage) a division based on a marital fraction (also known as a “couverture fraction” or “pro rata share”). This provides the ex-spouse with a share of the benefits earned during the marriage—excluding benefits earned before or after the marriage.

The standard formula usually looks something like this: “Fifty percent (50%) of the Marital Portion of the Husband’s vested accrued benefit under the Pension Plan as of the Husband’s date of retirement or the Wife’s benefit commencement date, if earlier. The Marital Portion shall be determined by multiplying the Husband’s vested accrued benefit by a fraction, the numerator of which is the number of months of the Husband’s service credit earned during the marriage (from [date of marriage] to [date of divorce]), and the denominator of which is the total number of months of the Husband’s service credit accrued Plan as of his date of retirement or the Wife’s benefit commencement date.”

Worth noting: It is possible to further restrict the benefits awarded to the former spouse by adding a date limitation to the denominator as follows: “…and the denominator of which is the total number of months of the Husband’s service credit accrued as of [date of divorce]."

COMMON MISTAKE #2Not Understanding the Difference Between Shared and Separate Interest

I often receive settlement agreements in cases for which I am asked to prepare QDROs for defined benefit plans, where it is clear to me that the parties and their advisors did not realize that the non-employee spouse does not have to wait until the employee retires in order to start receiving their share of the pension benefits.

Reality: A lot of divorce negotiations are based on this often-incorrect understanding that the former spouse cannot receive benefits until the employee does. Most (but not all) defined benefit plans will accept a “separate interest” QDRO if the employee has not yet started benefit payments at the time the QDRO is entered. The alternative is a “shared interest” QDRO, which is the only option available if the employee spouse has already retired and started receiving benefits at the time the QDRO is entered.

Under a separate interest QDRO, the former spouse’s benefit is truly separated from the employee’s benefit, and the former spouse can make independent decisions about the timing and form of the benefit. The former spouse can start their benefit payments at the earliest date that the employee can start—even if the employee does not start their benefit then. The former spouse could also take their benefit in any form available under the retirement plan—regardless of the form of benefit that the employee chooses.

Case in point: So the former spouse could, for example, decide to start their benefit payments when the employee reaches age 60, and choose a monthly annuity form of payment. The employee, however, could decide to wait to retire until age 65, and choose a lump sum payment. Neither party’s choices would affect the other’s, and the former spouse’s benefit will not be affected by the employee’s death once their benefit payments start.

Under a shared interest QDRO, everything is controlled by the employee. The former spouse has to receive their

“I find that even experienced divorce professionals do not always

know or understand the crucial differences between various types

of retirement plans.”

CONTRIBUTIONS vs BENEFITS Know the Difference

The most common example of a defined contribution plan is a 401(k) plan. In a defined contribution plan, the employee can make pre-tax contributions into an account maintained in his or her own name. The employer makes contributions of a fixed percentage of the employee’s salary into the account. In a defined contribution plan, there is no guarantee as to how much money will be in the account when the employee retires. That depends on the performance of the investments in the account over time. The only thing that is guaranteed, or “defined,” is the amount that the employer contributes periodically to the employee’s account.

By contrast, in a defined benefit plan, there is no specific account maintained separately for a particular employee; instead, there is a trust fund for all employees who participate in the plan. As employees accumulate years of service to an employer, they earn credit toward their retirement benefits. A traditional pension plan is the most common type of defined benefit plan, in which employees know that if they work for the company for thirty years, they will receive a monthly benefit of a certain dollar amount for the rest of their lives after retirement. Thus, the amount of benefit that they will receive is defined.

That is, an employee is guaranteed a certain benefit based on the employee’s length of service and salary at the time of retirement. u

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benefit at the same time and in the same form as the employee. A shared interest is required when the payments have already begun to be made to the employee, but if that is not the case, a separate interest QDRO provides much more flexibility.

COMMON MISTAKE #3Failing to Properly Address Surviving Spouse Issues

Family law attorneys often fail to make sure that both pre- and post-retirement surviving spouse coverage are explicitly addressed in the divorce agreement.

Surviving spouse benefits are probably the most complex area of QDRO practice, and while there are far too many issues involved to fully address here, financial planners should be aware of some of the most common pitfalls.

Divorce agreements should specify whether the non-employee spouse (“Alternate Payee”) is to be treated as the surviving spouse if the employee (“Participant”) dies before the transfer under the QDRO is completed.

For a defined contribution plan, this can be as simple as making it clear that the Alternate Payee is entitled to receive the funds awarded to them regardless of when the Participant dies (“Wife shall receive her portion of the Husband’s 401(k) Plan without regard to the death of the Husband”).

Many attorneys do not realize that, in defined benefit plans, payment of a surviving spouse benefit is substantially affected by whether the employee spouse dies before or after the commencement of benefit payments. Both situations must be

addressed in the QDRO, and thus should be spelled out carefully in the agreement.

Caveat: Special attention should be paid to what will happen if the Participant dies after the QDRO is entered but before the benefit payment has begun. Keep in mind that, since payments normally do not commence until the employee reaches retirement age, this period can last many years. In many defined benefit plans, the Alternate Payee will receive no benefits if the Participant dies before their payments begin, unless the Alternate Payee has been specifically designated as the surviving spouse for purposes of the Qualified Pre- Retirement Survivor Benefit (QPSA).

Moreover, the agreement should clarify whether the Alternate Payee is supposed to be the surviving spouse for the Participant’s entirebenefit or just for their portion of the benefit. For the Alternate Payee, this can mean the difference between having their benefit remain unaffected by the Participant’s pre-retirement death, and having their benefit reduced by half upon the death. This will also affect the Participant’s ability to leave a survivor benefit to any subsequent spouse.

Good idea: Some plans will accept language providing for the Alternate Payee to receive “that amount of the QPSA necessary to ensure that the Alternate Payee’s benefit is not reduced as a result of the Participant’s death prior to benefit commencement.” This is often a good compromise.

Financial advisors need to be sure that they understand exactly what will happen upon the Participant’s death, both before and after benefit commencement.

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As mentioned above, in most (but not all) defined benefit plans, a separate interest QDRO will insure that the Participant’s post-retirement death will not affect the Alternate Payee’s benefit. Therefore, the Alternate Payee does not need to be designated as the surviving spouse in order to receive their full benefit following the post-retirement death of the Participant. However, if the plan does not provide for a completely separate interest (and plans at many large corporations do not), then it is crucial that the Alternate Payee be designated as the surviving spouse for the appropriate portion of the Participant’s post-retirement survivor benefit.

Best practice: The parties should determine in advance whether the benefit will be paid as a separate interest

in which the death of the Participant will not affect the Alternate Payee. If not, the extent of the Alternate Payee’s interest in the post-retirement survivor benefit (often called the “Qualified Joint and Survivor Annuity” or “QJSA”) should be defined in the agreement.

Again, some plans will accept language providing for the Alternate Payee to receive “that amount of any post-retirement survivor benefit necessary to ensure that the Alternate Payee’s benefit is not reduced as a result of the Participant’s death following the commencement of benefits.”

If the Participant has already begun to receive benefit payments under the retirement plan, then it is normally not possible to do a separate interest QDRO. In that circumstance, the parties will generally need a “shared interest” QDRO; under the vast majority of plans, the surviving spouse designation made at the time of retirement will be irrevocable, even upon divorce.

One way to think about a shared payment QDRO after retirement is as a “check splitter.” Everything about the Participant’s benefit has already been permanently determined, including the form and amount of the benefit, and the designation of the surviving spouse. In most circumstances, all that can be done at that point under a QDRO is to send out two checks instead of one, providing a portion of each monthly payment to the former spouse.

What to Do When the Alternate Payee Dies

Financial planners should also be aware of what will happen to the Alternate Payee’s benefits upon their death, before and after benefit commencement. Generally, the benefits will revert to the Participant if they have not begun to be paid to the Alternate Payee before death, but some plans instead provide that the benefits will revert to the plan. In most (but not all) cases, the QDRO can be drafted to provide for either result.

If the Alternate Payee dies after their benefit payments have begun, in most circumstances, the form of benefit elected by the Alternate Payee at the time of commencement will dictate the result. For example, a single life annuity payable for the lifetime of the Alternate Payee will obviously cease upon the Alternate Payee’s death, but a payment form with a certain term might continue to pay benefits to a designated beneficiary after the Alternate Payee’s death until the end of the term. Further, some plans permit the designation of

REVIEW THESE DEFINED CONTRIBUTIONS BASICS

Here’s a refresher on dividing retirement plans and what constitutes a “defined contribution.” Most financial professionals are aware that qualified retirement plans can be divided between divorcing parties by a Qualified Domestic Relations Order (“QDRO”), as set forth under the Employee Retirement Income Security Act (“ERISA”) and Section 414(p) of the Internal Revenue Code. Retirement plans governed by ERISA must permit the “spouse, former spouse, child, or other dependent” of an employee to receive a portion of the employee’s retirement benefits, if the court in any state domestic relations action orders such benefits to be paid to an appropriate “Alternate Payee.”

Rationale: Retirement benefits earned by an employee spouse under both defined contribution and defined benefit plans are regularly allocated between divorcing parties so that the non-employee spouse is able to receive a share of the benefits as alimony, child support, or the division of marital property. QDROs are most often used to divide marital property between spouses in divorce cases, but they can also be used in post-divorce actions to provide a source of payment for overdue support obligations, and they can be used to provide funds to anyone involved in any type of domestic relations action who meets the criteria under ERISA to be considered an Alternate Payee. u

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“contingent” or “successor” Alternate Payees in the QDRO, to receive benefits payable after the Alternate Payee’s death (for example, under a shared payment QDRO where the payments are being made for the lifetime of the Participant). The contingent Alternate Payees must meet the requirements to be considered an Alternate Payee under ERISA (a “spouse, former spouse, child, or other dependent” of the Participant).

The bottom line: Because so many variables can affect the payment of retirement benefits upon the death of either spouse following a divorce, financial advisors should make sure that they and their clients understand what will happen to the benefits upon the death of either party, before and after benefit commencement.

Beneficiary Designation Forms Determine Actions

Keep in mind that the Plan Administrator is required under federal law to follow the instructions of the employee as set forth on the plan’s beneficiary designation forms, regardless of whether there is a subsequent divorce decree or other estate planning document which purports to award the benefits to someone else. This affects the payment of both defined benefit and defined contribution payments, and often leads to litigation—for example, between the Participant’s estate and a former spouse when the Plan pays the benefits to a former spouse who is not entitled to receive the benefits under the terms of a divorce agreement, but who remains the designated beneficiary on file with the Plan Administrator. These cases can be heartbreaking, not to mention expensive and time-consuming for the estate.

Summing up: Financial advisors should confirm with their clients that all beneficiary designations are properly made and/or revised immediately following the divorce.

In the next issue: The series will conclude with Part 3,providing tips for avoiding common QDRO mistakes. u

EMILY MCBURNEY, P.C.

Emily is an Atlanta attorney whose practice has been devoted exclusively to QDROs and the division of retirement assets in divorce cases for nearly 20 years. In addition, she is a popular speaker and is frequently invited to give presentations on

this subject to legal and financial professional organizations nationwide. For more information, visit www.emilyqdro.com.