Aside from the family home, retirement accounts are often the biggest marital asset that must be divided in a divorce. Sometimes, spouses are able to work out a deal where one spouse retains their entire account balance in exchange for giving up interest in something else.
But in most cases, a retirement account is divided using a qualified domestic relations order, or QDRO for short.
For this to happen, an accurate valuation on a couple’s retirement accounts must be calculated. While that may sound easy on the surface, determining values can be far from an easy task to complete.
To better understand some of the more complicated aspects of how values are determined specifically on cash balance plans, I sat down with Matt Schwartz, an expert on the valuation and division of retirement benefits.
Let’s jump into that conversation.
A Primer on Cash Balance Plans
What are cash balance plans?
A cash balance pension plan is a defined benefit pension plan. But instead of being based on years of service and at retirement, it looks like a defined contribution or a 401k plan where a dollar value is attached to it in terms of a large lump sum.
But that dollar value doesn’t actually represent funds in an account somewhere; it’s a hypothetical actuarial present value of the benefit that’s been accrued under the plan.
The plan statements show a pay credit and an interest credit that go towards this lump sum. But in terms of how the plan itself is funded, and how the plan itself works, it really is a defined benefit plan under the hood. It just looks like a defined contribution plan superficially.
So, the value that’s listed on the statement, is that the representative value that should be used when thinking about dividing funds in a divorce?
Yes. Because that is the actual value that the plan will pay. The one thing to be careful about is that for some plans, they’ll pay that amount now. For some plans, they still have to hit a normal retirement age or retirement age in the future. So you just need to be mindful of that when you’re assigning a value or considering a value on that statement.
It’s not like it’s a plan where it’s just a part of the statement, such as a public plan. It is actually a value that the plan will pay.
How are cash balance plans taxed?
The same as any other retirement plan. They’re pre-tax assets, so taxes are deferred until the time of payment. There wouldn’t need to be any special circumstances, as long as they were considered with other pre-tax assets.
How are cash balance plans invested?
Typically, very conservatively, due to how cash balance plans work. When a cash balance plan is established, there is a fixed annual interest credit rate that is stated every single year. And it’s typically 3% to 4%, and the plan has to accrue that amount. So, the plan investors look for safe harbor investments.
For example, T-bond rates, things of that nature, that are going to earn very close to a guaranteed rate of interest. That was the norm until 2010, when rules were changed, probably because it was recognized that so many people weren’t hitting 3% and 4% on their returns.
So, cash balance plan administrators were allowed to invest differently and provide an interest rate based on actual rate of return. They can invest funds however they want at that point, but they can assess that interest credit based on how the plan actually performs for that year.
The caveat to that is that administrators are still required to pay everything that’s been put in in terms of contribution. So, it’s not as though the cash balance plan value can reduce completely to nothing. But when a loss does take place, they’re able to post a loss for the year. But that’s still the minority.
Most plans still do pick effectively a safe harbor type rate of return. They are stating that the interest rates are 3% to 4% per year and are trying to hit investments that will do that. But it does allow the plan administrators to not have the responsibility to potentially make up losses the next year with contributions. Because of that rule change in 2010 does make things a little easier on plan administrators.
If you happen to have a year where there were losses, and that following year one of the participants wanted to roll over their lump sum balance, would the plan administrator need to make up from out of pocket for that difference?
Yes. The rule is that the amount that’s actually paid out cannot be less than the total pay credits.
Let me give you an example. Let’s say there is a short-term employee who has worked and contributed for five years. They put in $25,000 in pay credits, and that’s what the value is. But that last year was when they retired, there was a negative return, and it dipped below $25,000, the plan would still be obligated to pay the $25,000. They would have to make that up from a general plan trust or some other assets to get back to that point where the minimum distribution has to be in line with the pay credits that were made into the plan account.
How are cash balance plans paid out?
Most commonly they’re paid out as a lump sum. Most plans allow for their participants to convert that lump sum to a monthly payment. But that’s a minority election. Most participants simply elect to have it paid out under the lump sum option.
And that lump sum is allowed to be rolled over to an IRA?
Cash Balance Plans and Divorce
Let’s talk about cash balance plans and how they’re divided in divorce. If someone has a cash balance plan, what information should they obtain?
They would want an account statement. It’s similar to what you see from a 401k or a defined contribution plan. They’re only done annually, because the interest credit rate only hits once a year.
If the statement is acquired mid-year, you want to make sure that if it is represented to be sort of a mid-year statement that it actually has sort of a hypothetical interest credit or pay credit up to that point. And it’s not simply what it was from the previous year end. So that would be one thing to make sure. But generally, it’s simply an account statement, and you can look at it that way and compare it for value.
The one big caveat with having information you need for cash balance plan in divorce has to do with how the plan was established. Cash balance plans became very popular in the late 1990s and early 2000s, when companies were trying to reduce their pension plan liablities.
These companies moved from traditional defined benefit pension plans into cash balance pension plans. In some cases, they converted the previous traditional defined benefit plan into a conversion credit. In some cases, they froze the traditionally defined benefit pension plan and just started with a zero balance for the cash balance plan. So you want to make sure you know how the specific plan handled that conversion.
You’re going to want to know, because everything from conversion forward might need to be handled differently from what happened before that. That would definitely be something you would want to make sure is very clear for the purpose of division.
How would someone go about getting that information? Let’s say that their spouse has the cash balance plan. Who would they talk to, or what information would they need to get in order to figure out how the plan was established?
Typically, it’s indicated on the annual statement. There will be something that says a conversion credit or something along those lines on there, even if it’s been some years ago. If there’s any question at all, which there usually is, then they would want to contact the benefits department for the company and say, “How was the cash balance plan converted, or how was it established? Was it completely a new plan, beginning in 2003, or was there a conversion credit before that? How exactly did that occur?” The benefits department would be able to confirm that easily.
So, anything such as conversion credits or things of that nature is a sign that a spouse needs to do a little more digging.
Conversion, or transition benefit, is another one that we see a lot. Those are probably the big, big asterisk on these in terms of dissolution divisions. You want to make sure that assets are appropriately credited, because anything from when it started and going forward might need to be handled differently from that conversion credit in that previous plan.
And how do you determine the marital or community versus the separate property portion of a cash balance plan?
Well, the most accurate way is actually to trace it as you would a 401k plan or another defined contribution plan. And the reason for this is that the annual interest rates can vary a little bit. Even if they’re safe harbor, it might be 3% one year, it might be 4% one year.
You want to be able to apply that year’s interest rates appropriately to what the previous year end balance was. That’s the most accurate way to do it. That gets to be even more important when maybe there might be a conversion credit that’s attributed previous service. You’d want to make sure that’s handled with the appropriate apportionment method, which would simply be the time rule if the conversion credits was from a traditional defined benefit plan.
However, statements can sometimes be difficult to obtain. Or impossible. Particularly given the circumstances. Because of this is it still acceptable to simply apply a time rule fraction to the cash balance plan. Because it is ultimately a defined benefit plan, the funding requirements are based on defined benefit requirements and things of that nature.
It’s not an egregious sin to apply a time rule to this type of cash balance plan.
If all the statements, all the documentation is available, then it probably makes sense to do a more detailed tracing. And if not, as a proxy, the time rule would be an appropriate way of looking at that? Is that right?
Correct. Yes. In a best case, trace. If it’s not available, then the time rule is totally fine.
And how is a cash balance plan divided in divorce? What are the options, and what should people be aware of? Or what do they need to do?
They can absolutely be divided using a QDRO. Just as with other qualified retirement plans. That’s always an option. However, the value can certainly be offset with other community assets, as part of a global dissolution settlement. You just want to make sure you treat it as a pre-tax asset.
But the allocation options, or the division options for a cash balance plan are very similar to every other qualified retirement plan.
Anything else that people need to be aware of when it comes to dividing cash balance plans in divorce?
The big one is definitely the conversion credit. That’s the one that people get stuck on, because you don’t want to have an omitted asset. If they’ve just sort of set the previous plan aside and forgotten about it and there is no conversion, that’s a big one. You definitely don’t want to have an omitted asset.