There are multitudes of retirement plan options in this day and age. Terms fly through the air like alpha-numeric soup: 401(k)s, IRAs, SEP IRAs, TSFs, HAS, et cetera. Some are pre-tax, some are not. And there are a myriad of laws and regulations controlling all of it. The best place to start is at the beginning. There are two basic types of plans, a Defined Contribution Plan and a Defined Benefit Plan.
Defined Contribution Plans
A defined contribution (DC) plan is a type of retirement plan in which the employer, employee or both make contributions on a regular basis. Individual accounts are set up for participants and benefits are based on the amounts credited to these accounts (through employee contributions and, if applicable, employer contributions) plus any investment earnings on the money in the account. In defined contribution plans, future benefits fluctuate on the basis of investment earnings. The most common type of defined contribution plan is a savings and thrift plan. Under this type of plan, the employee contributes a predetermined portion of his or her earnings (usually pretax) to an individual account, all or part of which is matched by the employer. All gains and losses are credited to the individual account. Upon retirement the balance is used by the individual to provide retirement benefits.
The U.S. Code specifies a defined contribution plan as a “plan which provides for an individual account for each participant and for benefits based solely on the amount contributed to the participant’s account, and any income, expenses, gains and losses, and any forfeitures of accounts of other participants which may be allocated to such participant’s account.”
Defined Benefit Plans
A defined benefit pension plan is a type of pension plan in which an employer/sponsor promises a specified pension payment, lump-sum (or combination thereof) on retirement that is predetermined by a formula based on the employee’s earnings history, tenure of service and age, rather than depending directly on individual investment returns. Traditionally, many governmental and public entities, as well as a large number of corporations, provided defined benefit plans, sometimes as a means of compensating workers in lieu of increased pay.
In the private sector, defined benefit plans are often funded exclusively by employer contributions. For very small companies with one owner and a handful of younger employees, the business owner generally receives a high percentage of the benefits. In the public sector, defined benefit plans usually require employee contributions. Over time, these plans may face deficits or surpluses between the money currently in their plans and the total amount of their pension obligations. Contributions may be made by the employee, the employer, or both. In many defined benefit plans the employer bears the investment risk and benefits from surpluses because the benefit to the individual was pre-determined via a formula.
For example, if Eric Employee is due to receive a monthly benefit of X based on his salary history, tenure with the company, and any other factors already set as conditions on the formula, then he will receive X per month upon retirement regardless of whether his employer has made investment decisions that grew or dissipated the pension fund. The employer absorbs the loss or gain, and Eric receives the same amount either way. This is why the news may report on pension funds that have been illegally depleted. A government entity may decide to “borrow” against a public employee pension for a specific project, with the intent of paying it back, but then cannot. A CEO or president may be convicted of a white collar crime because he divested a pension fund contrary to state or federal laws, or the governing rules of the company. The head of that company is then liable for the missing funds owed as payments to retired employees.
What’s the difference?
The U.S. Code specifies a defined benefit plan to be any pension plan that is not a defined contribution plan, where a defined contribution plan is any plan with individual accounts. A traditional pension plan that defines a benefit for an employee upon that employee’s retirement is a defined benefit plan.
Defined Contribution Plans do not require an actuary to calculate the lump sum equivalent unlike for defined benefit plans. The contribution amounts can clearly be tracked by the deposits made by the individual into the account. A defined contribution plan is a specific account for the contributing individual. Amy Attorney has contributed $50,000 over the course of her employment at a law firm. Larry Lawyer has been at the same firm for the same amount of years, but Larry’s contribution has only been $25,000. The amount received upon retirement will fluctuate based on the investment results, but whatever gains or losses result from Amy’s 50k contribution are hers and hers alone. The contributions of those two employees will not be comingled. There is more opportunity for gains and more risk of loss to the individual. Upon retirement the dollar amount is a specific number. If the participant outlives his or her anticipated lifespan and the plan is exhausted there are no automatic gains. The funds available for retirement are static, regardless of whether the participant lives to be 80 or 108.
By contrast, a defined benefit plan is one large fund maintained by contributions from the employer (and sometimes employees). Here, Amy and Larry would know exactly how much they would each receive from that fund upon retirement. No specific monies in that fund are earmarked for any specific individual. Therefore, if they were both at the same firm for the same number of years, and all other factors, such as salary, in their formula were equal, Amy and Larry would receive identical pension allocations. The other big difference is that a defined benefit plan is usually predicated on paying the employee a set amount for the entirety of his or her retirement (i.e. until death). There is no risk to the participant of outliving their retirement income.
A defined benefit plan is ‘defined’ in the sense that the benefit formula is defined and known in advance. Conversely, for a “defined contribution retirement saving plan,” the formula for computing the employer’s and employee’s contributions is defined and known in advance, but the benefit to be paid out is not known in advance.
The distinction between the plans becomes important if the plan’s participant goes through a divorce. In most instances, retirement accounts are treated as marital assets and need to be divided and distributed as part of the dissolution of the marriage. An asset cannot be divided if the value is not known.
Valuation of Retirement Assets
As mentioned above, in order to divide a retirement plan, one must first value it. Keep in mind that in New Jersey a non-participant spouse is entitled to 50% of the marital portion of a retirement plan. Contributions made or benefits earned prior to and subsequent to the marriage are not subject to division. If Larry Lawyer has been making contributions to a Defined Contribution Plan for 15 years, and has been married for 10 of those years and he needs to divide that asset for purposes of divorce then his wife, Lucy, will not receive a portion of the funds he contributed prior to the marriage. If Larry continues making contributions after the divorce (or in some cases the date the divorce complaint is filed) Lucy is not entitled to a portion of those funds either.
It is relatively easy to value a defined contribution plan. Look at the amount on the statement from approximately the date of the marriage and the one from the date of separation (or filing of the complaint, or Final Judgment of Divorce, whichever cutoff date is agreed upon between the parties). Now you subtract one number from the other.
The valuation of a defined benefit plan is not easily calculated, and requires an actuary or actuarial software. However, even with the best of tools, the value of a defined benefit plan will always be an estimate based on economic and financial assumptions. These assumptions include the average retirement age and lifespan of the employee, the returns to be earned by the pension plan’s investments and any additional taxes or levies. A pension has to be valued because it takes into account those other facts and generally pension statements do not provide values of the entirety of the plans.
The valuation of the whole plan is then subject to a distributive ratio that is established by dividing the duration of plan participation (in months) by the duration of the marriage (in months). Using such a formula, the non-participant spouse’s share is therefore proportionate to the length of the marriage while the plan participant was covered by the plan.
Division of Retirement Assets
Once a present value is determined, there are different methods of dividing the retirement account: The Immediate Offset Method, The Deferred Distribution Method, or the Rollover Method.
Under the Immediate Offset Method, the present value of the retirement benefit is compared to the value of other marital property. The spouse who earned the retirement account retains the rights to it and the other spouse is given another marital asset of equal value in return for waiving his or her interest in the account. However, this method is only available if the value of the retirement account can be determined.
Under the Deferred Distribution Method, the benefits are not divided until such time as they are payable under the plan, at some future date. The division of benefits is usually set forth in a something called a Qualified Domestic Relations Order or QDRO. QDROs are governed by federal ERISA (Employee Retirement Income Security Act of 1974) regulations. As you might surmise, the business of QDROs can get complicated fast and almost always require outside assistance.
Under the Rollover Method the marital portion of the plan(s) is rolled over (without a tax penalty) into an IRA for the non-participant spouse. This is especially useful when a plan does not allow for an alternate payee, as is used in the deferred distribution method. For example, certain military retirement plans are not subject to deferred distribution if the marriage was less than 10 years. If there are not enough marital assets to use the offset method, and an alternate payee is not allowed, then a rollover is the only other option to divide the plan equitably at the time of the divorce.
Given the myriad of factors and concerns that are involved with valuing and distributing retirement plans, not to mention all the factors involved with negotiating that distribution, it is always wise to seek the advice and advocacy of experienced counsel. When it comes to divorce, you do not want to go through the process alone. You need counsel who can answer all of your questions and protect your best interests throughout the process.