The first step is understanding that divorce is emotionally difficult to negotiate for both sides. It is even more challenging if the two sides start from different vantage points. Just remember how you felt the last time you dealt with someone with a completely different perspective. For example, think of the last time you tried to persuade your toddler to eat his or her vegetables. You and your spouse cannot have all your questions answered in one workshop or a dozen. Divorce is way too complex for that. But you will both learn something. And most importantly, you will both hear the same information and may learn the same thing. And that can form the basis for a productive negotiation and path forward.
Jill came to our office for post-divorce financial planning. At 60 years young with two grown children, she wanted to know whether she would make it through retirement without running out of assets. A former stay-at-home Mom and current yoga instructor, Jill did not have a professional career. Her work-life consisted of a series of part-time jobs scheduled around her children’s.
Jill traded her interest in her ex-husband Jack’s 401(k) for half of a brokerage account, her IRA, and the marital home. Their lawyers decided that Jack’s 401(k) should be discounted by 25%. That would account for the fact that the 401(k)’s pretax assets would be taxed by Uncle Sam and her State tax authority upon distribution.
Adjustments to the Value of a 401k
That sounds reasonable on the surface. But was a 25% discount appropriate for Jill? After making some retirement income projections, it became clear that Jill would likely always be in a lower federal tax bracket than 25%. Had Jill consulted a Divorce Financial Planner at the time of her divorce, he or she would probably have advised against agreeing to a 25% discount to the value of the 401(k).
Jill and Jack also agreed that she would keep half of her interest in Jack’s defined-benefit pension that he earned as a pediatrician with a large hospital. When they agreed to divide the pension, Jack was unclear about the value of the pension. He thought that it was probably “not worth much anyway.” Neither lawyer disagreed.
After some research, I found that Jill would end up receiving a little over $33,000 a year from the QDRO of Jack’s pension. This is significant for a retiree with a projected spending requirement of less than $5,000 a month!
Since Jack and Jill planned to retire in the same year, she would be able to start receiving her payments at the same time as Jack. Also, Jack had agreed to select a distribution option with a survivor’s benefit for Jill.
That would allow her to continue receiving payments when Jack passed away. Jill was aware that women tend to outlive men. So, she was relieved that the survivor benefit was there.
In her case, Jill’s share of the pension was 50% of the marital portion. Was it the best outcome for Jill? It is hard to re-assess a case after the fact. However, had she and Jack known the value of the pension, they might have decided for a different division that may have better served their respective interests. Jill may have decided that she wanted more of the 401(k), and Jack could have decided that he wanted to keep more of the pension. Or possibly Jill may have considered taking a lump-sum buyout of her claim to Jack’s pension. Whatever the case, Jill and Jack would have had the explicit information to decide consciously rather than taking the default path.
The news that Jack’s QDRO’d defined benefit pension had value was serendipity for Jill. Increasing her projected retirement income with the pension payments meaningfully increased her chances to live through retirement without running out of assets. But it is possible that a better understanding of the pension division and other financial issues at the time of divorce could have resulted in an even more favorable outcome for Jill.
When the Social Security Act passed in 1935, it included benefits for workers, but not for their spouses. At the time, women who did not work outside of the home could not qualify for Social Security retirement benefits. A sweeping series of amendments enacted in 1939 extended Social Security to spouses and minor children. Wives who had not earned a social security retirement benefit or whose retirement benefit was less than 50% of their husbands qualified for the first time.
Catching up with a changing society, another reform extended Social Security retirement benefits to divorced wives in the cases when the divorce happened after a marriage longer than 20 years. The word “spouse” replaced the word “wife” in the 1970s, allowing husbands to collect retirement benefits on their ex-wives record.
Later, the length of marriage required to qualify for benefits after a divorce was reduced to 10 years. When SCOTUS legalized same-sex marriage in 2015, survivor and divorce benefits extended to same-sex couples.
This short history of Social Security shows how it has evolved over time. Ex-wives and ex-husbands can now all receive retirement benefits based on an ex’s work record. However, qualifying conditions must be met.
The rules can be confusing and difficult to keep track of, especially for those who have had more than one marriage and divorce or those whose ex-spouse has died.
Let us take the case of Jack and Jill, who are divorced. Jack’s PIA is $2,800. In this example, Jill does not qualify for a retirement benefit on her own record. She files for her divorced-spouse benefit at her full retirement age of 66. She will qualify to receive 50% of Jim’s Primary Insurance Amount, $1,400, as her divorced-spouse benefit.
The earlier you claim your benefits, the less you will get, consistent with other Social Security benefits. Conversely, you will receive more if you claim when you are older. To maximize Social Security benefits, you will need to delay them until 70 years of age.
It’s worth noting that when Jill’s own benefit is more than 50% of Jack’s, she will receive her Social Security retirement. She will not receive her benefit amount as well as 50% of Jack’s!
Sometimes people wonder how their age difference with their ex-spouse can affect their benefits. The good news is that the ex-spouse’s age when they claim is not relevant. As long as Jill claims at full retirement age, she will receive her maximum benefit independently of the timing of Jack’s claim.
A person who claims his or her benefits based on a former spouse’s record must be single at the time. So unfair, you say? If Jill, in our example, has remarried, generally she could get 50% of Jack’s benefits, or her own, if her own is greater than 50% of their Jack’s.
Jack may be married or unmarried. It makes no difference. If Jack happens to be (re)married, Jill and the current wife could both get the 50% benefit from Jack’s record. For that matter, they can both get upgraded to the full benefit at full retirement age.
Suppose Jill, who receives the 50% benefit, remarries. In that case, her 50% benefit from Jack’s record stops, unless Jill’s new spouse also gets a divorced spouse benefit. That’s except if the remarriage occurs after age 60.
Sometimes people are not sure when they actually got divorced. People often mark their court appearance date as the divorce date. In most states, however, the real divorce date is later than the court appearance. For example, in Massachusetts, it is 90 or 120 days later, depending on the type of filing.
More Marriages and Divorces
People sometimes ask: what if you had two or more ten-year marriages?
For example, let’s suppose that Sheryl was married to Patrick for 20 years and John for 12. Sheryl has now divorced for the second time and has remained single for more than two years since her last divorce from John.
Patrick’s PIA is $2,600, and John’s PIA is $2,400. Let’s suppose again that Sheryl doesn’t qualify for a retirement benefit based on her own record. However, she is at full retirement age (66 or 67, depending on the birth year).
When Sheryl files, she can receive half of Patrick’s PIA because it is higher than John’s. And, no, she cannot get both Patrick’s and John’s retirement benefits!
If Sheryl divorced less than two years before, she must wait until her last ex, Patrick, in this case, has filed for his benefit. The worker on whose record the retirement benefit is claimed, Patrick, must have reached 62 years of age.
If they divorced more than two years before, Patrick’s filing status is irrelevant to Sheryl’s claim. Unless Sheryl tells him, Patrick will never know if his ex has claimed.
Let’s go over the case of Mike and Marie. They were married for more than ten years and divorced for more than two. Mike and Marie are both 62 years old. She has not remarried. Because she is single, Marie qualifies for a divorced-spouse retirement benefit based on Mike’s record, whether or not Mike has filed. It’s worth keeping in mind that the earlier someone claims, the less they get!
If Mike has passed away, Marie receives a divorced-spouse survivor benefit based on Mike’s record, if she is currently unmarried or, if remarried, remarried after age 60.
In addition, Marie’s benefit will be 100% of Mike’s Primary Insurance Amount (PIA), the amount that Mike would have received at full retirement age (66 or 67). In the case of Mike dying, Marie’s retirement benefits are capped to full retirement age.
What if the same two people have married, divorced, remarried, and divorced again? In that case, the length of the two marriages can be added together (including the time in between) to reach the ten years qualifying minimum. That is if the second marriage (the remarriage) happens before the end of the calendar year following the divorce!!
We can make sense of this chaos. Say Mike and Marie were married seven years from May 2002 to August 2009. They remarried in December 2010 and re-divorced in November 2013, for three years. The total for the two marriages is ten years. Mike and Marie meet the 10-year requirement because their second marriage happened before the end of the calendar year after the first divorce. If instead Mike and Marie had remarried in January 2011, the ten-year clock would have been reset to zero.
What if Jill, the person applying for the divorced-spouse retirement benefit, also worked for an employer not participating in the Social Security system? For example, many state and municipal governments are exempt from the Social Security system. If Jill worked for a local government, she could qualify for a pension from her employer. Then, her divorced-spouse Social Security benefit would be reduced by 2/3 of the amount of her pension because of the Government Pension Offset rule. Depending on the size of her pension, Jill’s Social Security benefit may be zero.
How would that work? Jill currently receives a $3,000 monthly pension from a police department in Texas. She has divorced from Jack after a marriage that was longer than ten years. Jack’s PIA is $2,800. Jill’s divorced-spouse benefit of $1,400 would be reduced by $2,000 (2/3 of $3,000), which reduces the benefit amount to zero.
If Jack dies, Jill becomes eligible for a divorced-spouse survivor benefit. After the GPO reduction she will receive $800 ($2,800 – $2,000 equals $800).
Suppose the spouse with benefit also qualifies for a pension from an entity that doesn’t pay into social security. In that case, the Windfall Elimination Program kicks in. That reduces the spouse with benefit’s payments, and the ex-spouse’s benefit adjusts downward as well.
When you don’t have the ex’s Social Security number, you may need more information, such as his birth date and previous addresses. In this case, the Social Security Administration won’t make the process easy.
It is health insurance plan signup season . Whether you subscribe to your employer’s health care insurance plan or you buy your own directly, it is the time of the year when you have to sign up all over again. Unless you have specific circumstances such as a change of employer, a divorce, or new baby, this is the one time in the year when you get to change your health care insurance plan.
If you have been keeping abreast of the popular financial media, you may have come across the Health Savings Account (HSA). According to AHIP (America’s Health Insurance Plans), 22 million people had HSA accounts in 2018. Financial Planners love HSA. It is potentially the most tax advantageous vehicle that exists. Contributions to HSAs are pre-tax, the money is invested tax-free, and distributions are tax-free if used for health purposes. Triple tax-free. HSAs are even better than Roth retirement accounts !
The reality is that we all have health care expenses, and they can be substantial . Having the ability to pay with tax-free money is a critical advantage. If you have to pay a $100 hospital invoice, you might have to earn $150 or more first, pay Federal income taxes, Social security taxes, state income taxes, before you can have $100 to pay your bill. With an HSA, there is no income tax, you pay with $100 of your earnings.
A Health Savings Account is effectively an alternative to the Flexible Spending Account (FSA) , the more traditional way to pay for health care expenses that are not covered by insurance. The FSA allows employees to save pre-tax from earnings, and then to spend it on health care expenses without paying taxes on the earnings. Money in FSAs, however, is not invested, and it must be spent by year-end or be forfeited. It has to be spent, or it will be lost. HSA funds, on the other hand, can be invested, and funds from HSA accounts can be carried over into the future. Thus, HSAs can be spent in a way that is similar to other retirement savings accounts such as the IRA or the Roth IRA.
Contributions are pre-tax
Funds are invested tax-free
Distributions are tax-free (1)
Distributions can be taken in the future
If used as intended for retirement, education or health expenses respectively
What’s in it for the employer?
In order to contribute to an HSA, you must have chosen a High Deductible Health Plan with your employer.
According to the IRS, for 2019, a high deductible is defined as $1,350 ($1,400 in 2020) for an individual or $2,700 for a family ($2,800 in 2020.) On top of this high deductible, annual out of pocket expenses (including deductibles, copayments, and coinsurance) cannot exceed $6,750 for an individual or $13,500 for a family. Those numbers increase in 2020 to $6,900 for an individual and $13,800 for a family.
For employers, offering high deductible health insurance plans is more cost effective than other plans. Therefore, they will prefer that their employees sign up for high deductible plans. Many employers will contribute directly to HSA accounts to encourage their workforce to choose a high deductible health insurance plan.
Theoretically, if employees have to pay out of pocket or out of their HSA for their health care expenses, they will be more careful about their choices. While the funds in the HSA remain available to be used for health care expenses immediately if needed, the designers of the HSA believe that the ability to carry over HSA balances to future years will motivate employees to be better health care shoppers when choosing treatments or, indeed, when choosing to be treated in the first place. The net result is that high deductible health plans help employers contain health care expenses, and shift the burden on their employees.
And how do you maximize the value of the HSA? By contributing to the maximum, and investing it. A dollar contributed may be worth many times its value in the future when invested.
The Internal Revenue Service allows individuals in 2020 to contribute up to $3,550 to their HSAs. Families may contribute up to $7,100. Both individuals and families can benefit from a catch-up provision of $1,100 if they are over 55.
If you are choosing the high deductible plan to save money, but you are not able to contribute to your HSA, you are putting yourself at risk if you have an unforeseen health event. Not having enough saved to cover the cost of the health care you need means that you may have to go into debt until you have met your plan’s deductible.
So, if you have a tight budget, please think twice before trying to save money with a high deductible plan. It may just backfire on you.
A question that is often minimized at enrollment time is what happens to the HSA if you have miscalculated, and you happen to have a significant health care expense in the year that you are contributing?
First, if it is a major event, you may consider using funds in your HSA account. However the health care insurance will eventually kick in and cover most of the cost. So as a subscriber to a high deductible plan, you are still protected from the catastrophic consequences of an unexpected health issue. While you may not harvest all the benefits of the HSA, and you will likely lose the cost savings of choosing a high deductible plan, you are protected from financial disaster.
What if it is not a reallymajor event, just a somewhat major event like, say, a trip to the emergency room for a temporary issue that you will easily recover from?
In that case, you also have the option to use your funds in the HSA to pay for those expenses. Your contributions will have been pre-tax as with an FSA. You will not have enjoyed much investment growth. Your distribution will still be tax-free. You are giving up the future benefits of the HSA, but you are dealing with your more immediate issues. Basically, your HSA will have functioned like an FSA. You will also lose the savings benefits of choosing a lower cost high deductible plan over a higher cost low deductible plan.
What if instead, you decide to pay for your trip to the emergency room out of pocket with post-tax savings and save your HSA for the future, as your wealth manager told you that you should? The real cost of your $5,000 trip depends on your income and tax bracket. If you happen to be in the 32% Federal tax bracket and you live in Massachusetts, the cost of the $5,000 emergency room trip will be around 58% higher.
HSAs provide some tremendous benefits that should be considered by everyone who is looking to enhance their health care and their retirement situation. However, the decision to choose a Health Savings Account should be based on more than just taxes and the cost of your health care insurance. It is important to consider the very real costs of unforeseen events and to be realistic about your health insurance needs.
On April 4th, it was announced that McKenzie Bezos would be receiving 36 billion dollars worth of assets from her divorce from Jeff.
First of all, congratulations to Jeff and McKenzie for keeping this divorce process short, out of the media as much as possible, and out of the courts. We are not going to know the details of the Bezos’ agreement. However, some information has been disclosed in the press.
As reported by CNN, McKenzie is keeping 4% of their Amazon stock, worth approximately 36 billion dollars. Jeff retains voting power for her shares as well as ownership of the Washington Post and Blue Origin, their space exploration venture. According to The Economist, this makes the Bezos divorce the most expensive in history by a long shot.
Unsurprisingly, McKenzie’s wealth is concentrated in AMZN stock. That has worked out well for the Bezos’ for the past several years. It is likely to continue to be a great source of wealth for both of them in the future. As it stands, McKenzie is now the third richest woman in the world. Who knows, if she holds onto AMZN stock, she could become the richest woman in the world one day! McKenzie’s concerns with budgeting, taxes, and wealth strategy will soon be in a class of their own.
There are, however, some lingering considerations for McKenzie, particularly when it comes to capital gains taxes, portfolio management, philanthropy and wealth transfer.
A benefit of keeping the stock until her death is that her estate will benefit from a step up in cost basis. This would mean that the IRS would consider the cost of the stock to be equal to the value at her death. This favorable tax treatment would wipe out her capital gains tax liability.
Nevertheless, the standard advice that wealth strategists give clients with ordinary wealth applies to Ms. Bezos as well: it would be in McKenzie’s best financial interest to diversify her holdings. Diversifying would help her reduce the risk of having her wealth concentrated into a single stock. It is a problem that McKenzie (and Jeff) share with many employees of technology and biotech startups.
An advantage of having more money than you need is that you have the option to use the excess to have a measurable impact on the world through philanthropy. In 2018, Jeff and McKenzie created a $2B fund, the Bezos Day One Fund, to help fight homelessness. Given that the home page of the fund now only features Jeff’s signature, this may mean that Jeff is keeping this also. McKenzie will likely organize her own charity. What will her cause be?
McKenzie’s net worth is far in excess of the current limits of federal and state estate taxes. Unless she previously planned for it during her marriage, she will have to revise her estate plan. Even though she would benefit from a step up in basis on her AMZN stock if she chooses not to diversify, she would still be subject to estate taxes, potentially in the billions of dollars.
Of course, no matter how much estate tax McKenzie ends up paying, it is likely that she will have plenty to leave to her heirs.
Making Your Post-Divorce Portfolio Reflect the New You
Divorce is the final step of a long process. Whether the marriage was long or short, the end of marriage brings about the conclusion of an important phase of your life.
Divorce is an emotional event sometimes anticipated years in advance and at other times coming totally out the blue.
In all cases whether anticipated or not, divorce is a stressful event. According to the Holmes-Rahe Life Stress Inventory Scale divorce ranks as the second most stressful event that a person can experience in a lifetime.
For one, the dollar amounts are less than before and your current investment strategy reflects your goals as a couple rather than your own objectives going forward.
Moreover, most likely your confidence is a bit shot and your desire to take much investment risk is lower than before.
Ok, are you with me? You can control this aspect of your new life. What steps should you take to get the ball rolling?
We suggest an approach rooted in our P.R.O.A.C.T.I.V.E methodology.
The first step involves thoroughly examining your new situation from a non-financial standpoint. Where do you want to live? What type of lifestyle are you looking for? If you have children what type of issues do you need to account for?
The second step is to re-evaluate your comfort with taking investment risk. Now that you are solely in charge of your financial life how do you feel about taking on risk? Are you comfortable with the inevitable stock market swoons that occur periodically? Are you able to think as a long-term investor given your recent divorce?
The next step is really important. Your post-divorce portfolio needs to work for you. Establishing a hierarchy of financial objectives will drive the type of strategy that is most appropriate for you.
Is your primary objective to save for retirement? Do you have any major objectives besides retirement? Maybe you need to fund college tuition for your two kids. Maybe you plan on buying a new home in 2 years once your life has settled down?
Next you need to deal with the nitty gritty of figuring out exactly what you own and cash flow budgeting. What you own should not be difficult to figure out as you have just gone through the divorce process.
The second part of cash flow budgeting is often highly sensitive for people not used to budgeting during their marriage. If you have never had a budget or stuck to one this step seems like a major imposition. But unless money is so plentiful you have no choice.
At least for a period of time you will have to keep track of your expenses and gain an understanding of where the money is going. The reason this is important is that you may need to tap into portfolio gains to fund your living expenses. If that is the case, your portfolio should be structured to write you a monthly check with a minimal amount of risk and tax consequences.
The next step in the P.R.O.A.C.T.I.V.E process is to evaluate your tax situation. If you are in a high tax bracket you might want to favor tax-advantaged investments such as municipal bonds. If your income is going to be taking a hit post-divorce you probably will end up in a lower tax bracket increasing the attractiveness of a Roth conversion to your traditional individual retirement account.
The last three steps all involve figuring out how best to construct your investment portfolio. Going from your pre-divorce portfolio to something that fits your needs and goals will usually require some major re-adjustments in your strategy.
Going through our P.R.O.A.C.T.I.V.E process or a similar approach is probably the last thing you want to do on your own. Most likely you will need the help of an advisor to work through this.
Keep in mind that the reason you are doing this is to regain control over your financial life. You sought the help of a lawyer during your divorce. Now is the time to move forward and seek the help of financial professionals with an understanding of your situation and new set of needs.
What is the best way to implement a portfolio strategy for newly divorced people?
The most important aspect of post-divorce portfolio is that it fits you and your new circumstances and desires. Using our P.R.O.A.C.T.I.V.E methodology as a framework for evaluating your needs and desires we suggest implementing a portfolio structure that encompasses three “buckets”.
A “bucket” is simply a separate portfolio and strategy that has a very specific risk and return objective. Each bucket in our approach is designed to give you comfort and clarity about its role in your overall portfolio.
What is the role of these “buckets”?
Each “bucket” has a very specific role in the overall portfolio as well as very explicit risk and reward limits.
We label our three “buckets” as the Safe, the Purchasing Power and the Growth portfolios.
The role of the Safe Bucket is to provide liquidity and cash flow to you to meet your short-term lifestyle needs. How much you have invested in your Safe portfolio is a function of how much money you need to fund your lifestyle over the next few years.
The second bucket – the Purchasing Power portfolio – is designed to allow you to enhance your lifestyle in terms of real purchasing power. What this means is that every year your portfolio should have a return exceeding inflation.
Finally, the third bucket – the Growth portfolio – is designed to grow your portfolio in real terms. This portfolio is designed to maximize your returns from capital markets and will be almost exclusively invested in higher risk/higher reward equity securities.
Going through divorce is one of the most stressful situations anyone can face. Transitioning to a new beginning may take a short term for some but for most people the period of adjustment is fraught with uncertainty and doubt.
People often worry about their finances and whether they can maintain their lifestyle. A life event such as divorce also tends to shorten people’s horizon as their outlook in life often lacks clarity.
The implications from an investment standpoint are primarily a temporarily diminished desire to take on portfolio risk and a shortening of time horizons. In English this translates to searching for greater certainty and not looking too far out.
Our P.R.O.A.C.T.I.V.E approach is designed to make your money work for what you deem important. Divorce is difficult and transitioning to a new beginning takes time. As you adjust to your post-divorce life your financial assets will also need to be managed consistent with the new you.
At Insight Financial we are experts at guiding you through this difficult adjustment period and transition into a new beginning. To read our full report on our approach for managing your post-divorce investments please click here.
Our wealth management team at Insight Financial Strategists is ready to help you in your transition. To set up an initial consultation please book an appointment here.
Although the number of pension plans has significantly declined over the years there are still many of them out there, and many divorcing couples have to figure out how to deal with them. The prime benefit that a pension plan provides is a fixed lifetime income. A stream of income in retirement could well be a pension synonym. It used to be that fixed income was considered a negative. However, nowadays it is the lucky retiree who benefits from a pension plan!
In case of divorce, issues surrounding who is entitled to the pension present a challenge especially in the case of grey divorces (usually defined as people over 50). Divorce and pension plans can sometimes generate conflict as the owner of the asset will often feel more proprietary about it than with other assets. Employees are often emotionally vested in their pension. They feel, more than with other assets, that they have really earned it. And that their spouse has not. They often will have stayed in a job that they may not have liked for the privilege of qualifying for a higher paying pension. Couples look forward to getting that income when they retire. And so spouses will want to make sure that they get their share of it as part of the divorce.
Pension rights after divorce are determined as part of the overall divorce process. In a negotiated divorce, the parties can decide, within limits, how to divide their assets. In the worst case, the courts will make the decision.
What is a pension plan and how does it work?
The value of a pension benefit can be difficult to determine. Unlike other accounts, pensions don’t come with a statement that makes them easily comparable to other assets; they come with the promise of a benefit (the monthly payment that someone might get at retirement). So the number one priority when a pension is involved in a divorce is to get a valuation. The financial consequences of divorce are serious, and not getting a valuation may lead to struggling financially after divorce
Risk of Valuation
Even when valued, the number provided on a report may lead to a false sense of security. Unlike other retirement statements, the value of a pension is estimated using the parameters of the beneficiary and of the pension. In most cases the divorce pension payout is calculated with a predetermined formula based on the employee’s length of employment and income. In some cases, the benefit may vary depending on a few other factors.
The next step is to estimate how long the benefit might be paid. That is done using actuarial tables. Based on periodic demographic studies, actuarial tables predict our life expectancy. Some actuarial tables include those produced by the Society of Actuaries, the Internal Revenue Service, and the Pension Benefit Guaranty Corporation (PBGC). A pension valuation will normally use the estimates from the actuarial tables representing an average life expectancy of a cohort of people born in the same year. The estimates are usually accurate within their parameters, as individual variability is smoothed out for large populations. However, individual longevity is harder to predict as it may fall within a wider range.
With the amount of the payment and the length of time that the payments will be made, how much is all of that worth? Pension valuators use a “discount rate” to approximate the value of a future payment. The principle is that the value of a dollar paid next year will be less than the value of a dollar paid today. Hence you should be willing to accept less than a dollar for the promise of a payment next year, and even less for the promise of payment the year after.
Financial analysts will use the concept of the prudent rate of return, the rate that a prudent person would invest at in order to receive that dollar next year or beyond. That of course could be subject to interpretation. Often the standard that is used is the government bond rate for the duration of the payment. US government bonds are often considered to be risk free by economists and the public, although that too is subject to debate (Currently US government debt is rated at AA+ (below AAA) by Standard & Poor’s, the leading debt rating agency). Nonetheless that rate is often used for individual pension valuations.
The PBGC, on the other hand, has developed its own rates. The PBGC uses different rates before retirement, and rates during retirement. The former are significantly higher than the latter and assumes a rate of return that is in excess of the risk free rate. That may be a better model for actual human behavior, as people will normally be tempted to take more risk for a better return, rationalizing, of course, that the incremental risk is not significant. On the other hand, for rates during retirement the PBGC uses rates that are well below the norm, reflecting the reality that retirees are even more risk averse than the average population.
Financial analysts will determine the value of the pension by taking a present value of the pension payments over the expected longevity of the individual at the determined discount rate(s). The number that comes out is usually a single number assuming a date of retirement.
Understanding that we are working with an estimate, people usually ignore the fact that the magic number does not take into account the likely variability of the inputs, in particular longevity.
If you will be the alternate payee (ie, if you are the spouse aiming to get a share of the other’s pension), it is important to pay attention to the fact that the real value of your share of the pension will fall within a range. It will not be a single number Hence when you trade that pension for another asset that has a fixed value, you want to make sure that you are not short changing yourself.
On the other hand if you are the beneficiary of the pension, it is painful enough to give up a share of it. You don’t want to give up part of that asset if it will not be fully used. If it is the alternate payee that passes away early, his or her stream of payments stops, and, in most cases, does not revert back to you, the initial beneficiary. If that were to happen you will have wasted a potentially substantial asset.
In summary it is important for divorcing couples to fully understand the value of their pensions for themselves and for their spouse. Divorce already destroys enough wealth. There is no need to destroy more.
Risk of Default
Pensions have a risk of default or reduced benefits in the future. According to the Society for Human Resources Management 114 pension funds are expected to fail in the next 20 years. That is true even for pensions that do not look like they are in trouble currently. Some people may think that this is farfetched. Yet you only have to look at the Pensions Right website to convince yourself that benefit reductions do happen. When you consider that retirement can last 20, 30 or 40 years, you will want to evaluate if your pension plan is robust enough to last that long, and continue making payments for that long.
The risk of benefit reductions or outright default may apply mostly to the private sector. Yet public sector plans may be at risk also. For instance, Social Security has a trust fund that, together with payroll deductions, funds its retirement benefits (social security retirement benefits are effectively a pension). According to the 2009 Social Security Trustees Report, the Social Security trust fund will run out in 2037. When that happens, the Trustees project that retirement benefits will be cut by 24%.
It should be noted that Social Security benefits are not divisible in divorce The beneficiary keeps his or her benefits. The ex-spouse can get 50% of the beneficiary’s benefits (if married 10 years or longer) or 100% of his or her own, whichever is higher, but not both. That happens without prejudice to the prime beneficiary.
However, in 2037, both parties can expect a Social Security retirement benefit cut of 24%, unless Congress remedies the situation beforehand.
People also underestimate personal risk. If you receive a pension as an alternate payee (ie the spouse who is getting a share of the pension from the former employee), you will want to consider the risks that your payments may be interrupted due to issues with your ex-spouse. Many pensions stop spousal payments when the beneficiary passes. When that happens, the alternate payee will have to find an alternate source of income to compensate.
It is worth remembering that our life expectancies are random within a range. The expected longevity of women reaching 65 years of age is to 85 years of age. We often anchor on this or other numbers forgetting that few women pass away at 85. Most will pass away either before 85 or after 85. According to a paper by Dr. Ryan Edwards for the National Bureau of Economic Research, the standard deviation for longevity is 15 years. That means that most women will live to 85, +/- 15 years. From 70 to 100 with an average of 85. That is a wide range! What if the beneficiary of the pension passes away 10 years before his her life expectancy, and the alternate payee lives 10 years longer than life expectancy? That means that the alternate payee may have to do without his or her share of the pension for 20 years or longer (if the two ex spouses have the same expected longevity).
And what about inflation risk?
Most pensions do not have a Cost of Living Adjustment (COLA). That does not apply to all of them. For instance, the Federal Employee Retirement Systems (FERS) has a limited COLA. Effectively, when there is no inflation adjustment, the value of a pension payment is reduced every year by the amount of inflation. How bad can that be, you ask? Assuming a 3% inflation rate the value of a fixed payment will decrease by almost 50% over 20 years. . What is the likelihood that expenses will have reduced by 50%?
A Last word
Pensions are a very emotional subjects in divorce. Perhaps because we are naturally risk averse, and perhaps because our risk aversion is exasperated by divorce related anxiety, we like to cling to what we perceive as solid. People will often want to keep the marital home, even if they cannot afford it, or take a chunk of a pension even when it may make better sense to trade it for another asset. Worse yet they will want to know whether to keep the house or pension in divorce.
What other asset you may ask? You could trade the pension for a tax- deferred retirement asset, such as an IRA or a 401k. Or any other asset that you and your spouse own. The right decision will end up being different for everyone.
As a Divorce Financial Planner, it is my task to make sure that each side understands exactly what is at stake, and to help prepare them for rebuilding financially after divorce. In many cases it makes sense for both parties to get a share of the pension. In others it does not. How to keep your pension in a divorce is a vital question. Even more important is to understand the true value of the pension, and its ambiguities. It is a difficult task in a process that is already filled with anxieties and uncertainties to focus effectively on yet one more ambiguity. Yet for successfully managing finances after divorce it must be done.
Eliminating the deductibility of alimony payments from taxable income is one of the features of the Republican House Tax Reform bill. It is very significant to both payors and recipients of alimony.
The Goddess Nemesis
Written into the fabric of the GOP tax proposal is a change in how alimony is taxed. People paying alimony could lose “the greatest tax deduction ever.” And that could ultimately affect those receiving alimony, too.
Since details of the new tax overhaul bill were released on Nov. 2, people of all income levels and ages have been trying to figure out how they could be affected going forward. One group of folks not likely to be happy: those paying alimony.
Section 1309 of the House bill would eliminate the deductibility of alimony. Killing the alimony deduction is one of the smaller revenue targets for the House Republican tax bill, yet it is exceedingly significant to the people affected.
Under current rules, alimony payors may deduct their payments from their taxable incomes, thus lowering their income taxes. In return, recipients pay income taxes on their alimony income. Because payors are usually in higher tax brackets and recipients in lower tax brackets, families can save money on taxes by shifting the tax burden to the lower earner. The saving can help increase cash flow for divorcing couples. They can then decide how to allocate the savings: to the payor or the recipient … or the court can do it for them.
Killing the alimony tax deduction raises only about $8 billion over 10 years
According to the House, abolishing the alimony deduction would not be a large revenue generator. By killing the alimony tax deduction, the alimony tax bill raises only about $8 billion over 10 years. That is because the tax increase on payors is offset by a tax decrease for recipients. For them, alimony income would no longer be taxable.
This wrinkle could have a significant impact on divorce settlements. For many payors, saving taxes on alimony payments is the one pain relief that comes with making the payments. According to John Fiske, a prominent mediator and family law attorney, “Alimony is the greatest tax deduction ever.” Without the deduction, payors will find it much more expensive and more difficult to agree to pay.
For example, in Massachusetts alimony payors usually pay 30% to 35% of the difference in the parties’ incomes. For a payor in the 33% federal tax bracket, the House tax bill increases the cost of alimony by nearly 50%.
The entire set of laws, guidelines and practices around alimony are based on its deductibility. Passage of the House Republican tax bill is likely to lead to a mad scramble in the states to change the laws and guidelines to adjust alimony payments downward to make up for the tax status change.
The likely net result: although recipients would no longer pay tax on alimony income, abolishing the tax deductibility of alimony is likely to reduce their incomes even further as divorce negotiations take the new, higher tax burden on payors into account.
People will often feel very proprietary about their retirement accounts. They will reason that because the account is in their name only, as opposed to the house which is usually in both their names, they should be able to keep those accounts. Most of the time, this is flawed reasoning. The general rule is that assets that are accumulated during marriage are considered marital assets regardless of the titling.
However, there are cases when part of a retirement plan can be considered separate. This often depends on state law, so it is best to check with a specialist before getting your hopes up.
2. Can I Divide a Retirement Account Without Triggering Taxes?
Since there are so many different retirement accounts, the rules to divide them vary widely. Plan administrators will often recommend their own “model” QDRO. It usually makes sense to have a QDRO specialist verify that the document conforms to your interests.
In addition, that money that was set aside for retirement will no longer be there for that purpose. Although you might tell yourself that you will replace that money when you can, that rarely ever happens.
However, if you have no other choice, it so happens that divorce is one of the few exceptions to the penalty rule. A beneficiary of a QDRO (but not the original owner) can, pursuant to a divorce, take money out of a 401(k) without having to pay penalties. However, you will still have to pay income tax on your withdrawal. Note that this only applies to 401(k)s. It does not apply to IRAs.
4. How Do I Compare Retirement Accounts with Non-Retirement Accounts?
Most retirement accounts contain tax-deferred money. This means that when you get a distribution, it will be taxable as ordinary income. At the other end of the spectrum, if you have a cash account, it is usually all after-tax money. In between you may have annuity accounts where the gains are taxed as income, and the basis is not taxed; you may have a brokerage account where your gains may be taxed at long-term capital gains rate; or you may have employee Restricted Stock which is taxed as ordinary income. All of these accounts can be confusing.
In order to get an accurate comparable value of your various assets, you will want to adjust their value to make sure that it takes the built-in tax liability into account. Many divorce lawyers will use rules of thumb to equalize pre-tax and after-tax accounts. Rules of thumbs can be useful for back-of-the-envelopes calculations , but should not be used for divorce settlement calculations, as they are rarely correct.
Because these calculations are not usually within a lawyer’s skill set, many lawyers and clients will use the services of a Divorce Financial Planner to get accurate calculations that can form a solid basis for negotiation and decision making. It is usually better to know than to guess .
5. Should I Request a QDRO of My Spouse’s Defined Benefit Pension?
Another key consideration is that defined benefit plans are complex. Although they have common features, they are each different from one another, and each come with specific rules. You will be well advised to read the “plan document” or have a Divorce Financial Planner read it and let you know the key provisions.
A common provision is that the benefit for the alternate payee can only start when the plan participant starts receiving benefits and must stop when the plan participant passes away. It is all good for the plan participant. But what if as a result of that, the alternate payee ends up losing his or her pension benefits too early?
Hence a key issue of valuing defined benefit plans is that a true valuation is more than just numbers. It also involves a qualitative discussion of the value of the plan, especially for the alternate payee. Some Divorce Financial Planners can handle the valuation of interests in a defined benefit plan easily and the discussion of the plan. Others will refer you to a specialist.
The previous offer had come two days before their last court appearance. There was just not enough time to understand the implications of the various components of the offer and assess whether it was an equitable division of marital assets. Lindy was just too nervous to make the decision “on the steps of the courthouse”, so she said no.
No wonder divorce financial planning has risen as a specialty. Professionals dedicated to meeting the needs of divorcing individuals can help people such as Lindy and Ted understand the financial issues of divorce, negotiate settlements and recover into a financially stable post-divorce life.
In Lindy’s case, she was fortunate to be referred to a Divorce Financial Planner by a divorce coach. Divorce Financial Planners build on financial expertise often acquired by Certified Financial Planners (CFP®) or Certified Public Accountants (CPAs). They also often hold the Certified Divorce Financial Analyst (CDFA®) designation. They excel in their ability to simplify the complex financial issues of divorce so that people like Lindy and Ted can understand the consequences of their decisions and plan accordingly for their separate futures. In addition, Divorce Financial Planners bring to the table an understanding of tax issues in divorce, employee stock options, retirement plans, pension plans, Social Security, real estate and long-term financial planning.
They help assess potential outcomes of strategies such as trading home equity for ownership of retirement accounts—is that a good idea for you for the long term?
In Lindy’s case, the new offer seemed to address her needs better. Ted offered to give Lindy more of the 401(k) in exchange for keeping his pension. In addition, Ted offered more alimony.
However, Ted’s offer was still not clear about his employee stock options, as he did not know how to value them. In addition, the offer did not address the issue of college funding for their 13 year old daughter.
Lindy’s Divorce Financial Planner carefully reviewed the settlement offer in light of her individual circumstances, explained the various issues and made recommendations for her lawyer. After some more negotiations, Lindy and Ted were able to come to an agreement and avoid a costly trial. Even Lindy’s lawyer was happy with the process , as it helped him to focus on his area of expertise: writing the agreement and managing the legal process.
A previous version of this post was published in Kiplinger