Administering Cash Balance Pension Plans to Conform With Qualified Divorce Orders

Abstract

This article provides an overview of the unique issues that normally arise under a cash balance pension plan to conform with qualified domestic relations orders (or QDRO). Presently, many plan administrators treat a cash balance plan just like a defined contribution plan only to find that the benefits within a cash balance plan are not as easily divided as those within a defined contribution plan. The apparent similarity of hypothetical account balances in a cash balance plan and the actual account balances in a 401(k) plan can result in mishandled QDROs. The similarities between a cash balance plan and a traditional defined benefit plan can also confound plan administrators, particularly when a defined benefit plan was subsequently converted to cash balance plan. Then all or a part of a participant’s benefit subject to a QDRO has the option to be determined under a traditional defined benefit formula, such as a percentage of final average pay. And while a QDRO administered under a pure cash balance plan can split the benefit in a fashion similar to that used for 401(k) plans, QDROs remain distinct and involve important differences between a cash balance plan and a 401(k) or other defined contribution plans. These unique features of a cash balance plan can drastically affect the monetary impact on alternate payees. To fulfill the duties prescribed under both ERISA and the IRC, plan administrators must engage in a very targeted fact-specific analysis involving the participant (employee), alternate payee and the Plan within a taut web of federal laws, regulations and mandates.

Keywords

cash balance plans qualified domestic relations order QDRO divorce plan administrator domestic relations order DRO

Cash balance plans are defined benefit plans that have unique features similar to defined contribution plans.¹ Most significantly, the monetary benefit or value in an employee’s account is stated as a “cash balance.” This dollar amount appears to an employee the same as a 401(k) plan; each year employees receive “pay credits,” generally a percentage of compensation.² In addition, an “interest credit” is added to each employee’s account balance based on a specific rate of return or a variable rate tied to an index. Unlike a 401(k) plan, the employee has no input as to how the account balance is invested. All investment risks are borne by employers. Significantly, when their employment ends, employees can receive an immediate annuity or in many plans a lump sum distribution.

In recent years, cash balance plans have become quite popular. Most cash balance plans are “conversions” from a traditional defined benefit plan. Conversions make administering cash balance plans to satisfy a qualified domestic relations order (or QDRO) more complicated since the plan administrator must calculate the employee’s accrued benefits under the prior traditional defined benefit plan, and then convert these accrued benefits into an opening balance at the establishment date of the cash balance plan. Thus, if the parties were married prior to the conversion, it is critical for the plan administrator to know the conversion date and determine the cash balance to ascertain the alternate payee’s³ interest.

When a married couple divorces, a court may issue a “domestic relations order” (or DRO) that splits the value of a participant’s benefit between the participant and an alternate payee. However, this order must be a QDRO to satisfy the anti-alienation of benefits requirements of the Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code (Code).⁴

The plan administrator determines whether a DRO is qualified.⁵ A domestic relations order is a judgment issued by a state court, pursuant to each state’s domestic relations law, relating to the provision of child support, alimony payments or marital property rights.⁶ Whereas a Qualified-DRO is a DRO that assigns an alternate payee the right to receive a portion, or all, of a participant’s retirement benefit and satisfies certain requirements under ERISA and the Internal Revenue Code.⁷ The DRO must be submitted to the plan administrator, who reviews it for compliance with legal and plan requirements, and then qualifies the order, if appropriate. Of note, pension plans are not permitted to follow the terms of a DRO purporting to assign pension benefits, unless it is a QDRO.⁸

Before a DRO can be qualified, it must satisfy eight statutory requirements to be considered a QDRO by the plan administrator. A DRO must contain the following items for it to be a QDRO:

Delineate the methodology used to determine the benefit amount to be paid the alternate payee, or specify the monetary amount itself

The participant’s and alternate payee’s name and last known address

Each plan name to which the order applies

The time period to which the order applies⁹

The following must also be true about a DRO for it to be a QDRO. The DRO cannot require the plan

To provide an alternate participant with any type of benefit or option not already provided under the plan

To provide for increased benefit

To pay benefits to an alternate payee from another QDRO

To pay benefits to an alternate payee in the form of a qualified joint-and-survivor annuity for the lives of the alternate payee and his or her subsequent spouse¹⁰

Plan administrators cannot dictate the approach to splitting benefits. If ERISA and the IRC are not violated, the plan administrator must adhere to the requirements delineated in the DRO. Generally, the provisions of the QDRO must be followed as though they were part of the plan document (although the QDRO itself is subject to limitations) and includes providing the right to the alternate payee to elect the form and timing of the benefit.¹¹ However, complications arise when a company’s defined benefit plan was subsequently converted into a cash balance plan, then the QDRO rights of an alternate payee are protected under different components of ERISA and the IRC.¹²

Splitting QDRO Benefits From a Cash Balance Plan

There are two primary ways to split benefits under a QDRO¹³: a shared payment approach or an approach based on separate interests. Not understanding the differences between these two approaches and the basis for their utilization can often create undue confusion that could lead to an accepted QDRO wherein the alternate payee receives significantly more than a lifetime annuity or nothing at all or something in between. It all depends on whose life expectancy is used to determine the alternate payee’s share of benefits as well as the proper and legal elections by the parties.

Shared Payments

Under a shared payment approach, a portion of each future benefit payment is assigned to the alternate payee. Therefore, the alternate payee does not make any elections related to the benefit form or timing, and the alternate payee’s benefits will stop when the participant’s benefits stop (at the participant’s death), even if the alternate payee is still alive, except to the extent that the QDRO provides surviving spouse benefits (or other survivor benefits permitted under the terms of the plan).¹⁴

When a shared payment approach to splitting the benefits is used, it is common to share any early retirement subsidy with the alternate payee. In effect, the shared payment approach is meant to split a single check (payable to the participant) into two checks (payable to the participant and the alternate payee). The checks start at the same time, they stop at the same time (generally, on the participant’s death, although a surviving spouse benefit might then be payable to the alternate payee, if the QDRO so provides) and their values add up at to what would have been payable to the participant as a single check. Hence, if the participant is entitled to subsidized early retirement benefits, the alternate payee typically shares in that subsidy under the shared payment approach.

However, there are three disadvantages in utilizing the shared payment approach:

Until the participant actually retires and begins receiving benefits, the alternate payee cannot receive benefits. Furthermore, since the alternate payee’s share of the benefits is not actuarially adjusted to her life expectancy, her share of the benefits on her death will generally revert to the participant.

By choosing a joint-and-survivor annuity with their ex-spouse as the designated survivor annuitant, any subsequent spouse of the participant could be left without any share of the participant’s benefits after his/her death.

Unless the participant elects a postretirement joint-and-survivor annuity, the alternate payee’s share of the benefits cease at the participant’s death. If Joe died right after retirement, Mary would lose all her benefits unless Joe had elected a reduced joint-and-survivor annuity and the QDRO delineated Mary as Joe’s surviving spouse.

Separate Interest

Under a separate interest approach, the retirement benefit is split to provide the alternate payee with a separate benefit. Two distinct separate accounts are created, one for the participant and another for the alternate payee. Each account is actuarially adjusted for the lifetime of each party.¹⁵ This provides the alternate payee with her own separate interest in a lifetime annuity.

The alternate payee can choose any allowable form of payment and may also select a different commencement date to receive benefits different from that of the participant. If a separate interest approach is used, it is typical to provide the alternate payee all the flexibility as to timing and payment form available to the participant under the plan.

The participant can also choose any allowable form of benefits available, so if the participant is remarried, he can elect a joint-and-survivor benefit for the new spouse. A “separate interest” QDRO can thus provide the alternate payee a lifetime of benefits while simultaneously allowing the participant for his remaining share any form of benefits.

An express exception is that the alternate payee cannot select a joint-and-survivor annuity option with any future spouse of the alternate payee as the beneficiary.¹⁶ As to the alternate payee’s benefit, the plan can conduct various actuarial adjustments to reach an amount to be paid for life that on the alternate payee’s death would not revert to the participant. In other words, if Mary (alternate payee) predeceases Joe (the participant), after her benefit commencement date, Mary’s share of the benefits evaporates rather than reverting back to Joe. If, for example, the participant’s former spouse is in ill-health, a separate interest QDRO is ill-advised.

Also, because payment of the alternate payee’s separate interest must satisfy the required minimum distribution (RMD) rules, it is generally not possible for an alternate payee to elect a joint-and-survivor annuity with any beneficiary other the participant.¹⁷ If the plan and QDRO permit the alternate payee to a lump-sum distribution, this issue will be moot if the alternate payee elects a lump sum.

When a separate interest approach is used, early retirement subsidies can be offered to the alternate payee, or denied to them. But it should be noted that, in order not to increase costs to the plan, the value of any subsidy cannot be given to the alternate payee until the participant actually commences with a subsidized benefit. Therefore, if the alternate payee is entitled to early retirement subsidies under the QDRO, but commences before the participant, the alternate payee’s benefits would be actuarially reduced as normally required by the plan until the participant commences, at which time the alternate payee’s benefits would be increased to share in the subsidy. If the alternate payee elects a lump-sum payment prior to the participant commencing payment, providing the early retirement subsidies at the time the participant commences payment could require a second lump-sum payment to the alternate payee at that time.

In sum, the separate interest approach has three primary advantages when dividing benefits:

The participant can both protect the ex-spouse’s interest and need not make any choices which could jeopardize a future spouse.

The participant does not have to retire for the alternate payee to receive benefits.

Allows for more flexibility to both parties without an adverse financial impact.

With either approach, the QDRO rules do allow for some flexibility regarding payment form and timing. For example, the plan document could specifically (a) allow that alternate payees can be provided additional payment forms (lump sums, although most cash balance plans already provide a lump-sum payment form) and (b) allow that alternate payees can collect the benefit earlier than the earliest retirement age for participants under the plan (for most cash balance plans, that will mean the alternate payee can take distribution prior to the participant terminating employment, because that is usually the only requirement for a participant to take a distribution under a cash balance plan). Additionally, the QDRO itself can allow for the alternate payee to begin receiving benefits at the earliest retirement age under the plan even if the participant has not separated from service at that time (and therefore the participant would not be eligible to commence at that time).

Administering Preretirement Survivor Benefits Under QDROs?

All tax-qualified defined benefit plans must provide survivor benefits to the participant’s spouse if a married participant with a nonforfeitable benefit dies before commencing his or her benefit. If before retirement the participant dies, the alternate payee will receive a qualified preretirement survivor annuity (hereinafter referred to as a QPSA) in lieu of her regular assigned share of the benefits.

Inexplicably, some plan administrators do not require preretirement survivorship protection in a separate interest QDRO. This can cause an ill-fated domino effect. The thinking of the plan administrator is that an actuarially adjusted benefit under a QDRO secures the alternate payee’s benefits whether the participant dies before or after retirement (DOMINO 1).

Instead of requiring preretirement survivorship, the plan administrator may have an attorney include language in the QDRO such as: The plan administrator utilizes a totally severed approach in administering their separate interest QDROs and the participant’s death, either before or after retirement, will not affect the alternate payee’s rights to her benefits (DOMINO 2). This is “recommended” by the attorney in case the plan administrator subsequently modifies their QDRO procedures.

Unfortunately, this would unwittingly allow for a scenario wherein the alternate payee would receive an inequitable windfall (DOMINO 3). The alternate payee would receive both her assigned separate interest in the participant’s pension regardless of the participant’s death, and an additional preretirement survivor annuity in the event of the participant’s preretirement death. Given that this was never the parties’ intent, one should remove from the QDRO the preretirement survivor annuity language. Requiring preretirement survivorship protection in a separate interest QDRO in the first place would have prevented this travesty.

Absent a QDRO to the contrary, if before the participant’s annuity starting date a participant and their spouse become divorced, the divorced spouse loses all rights to the QPSA, and these rights will attach to any future spouse if the participant subsequently remarries. A QDRO, however, may require that a former spouse be treated as the participant’s surviving spouse for all or part of a QPSA. In this case, if the participant subsequently remarries, the participant’s new spouse will receive none of, or only a portion of, any survivor benefit on the participant’s death. If a separate interest QDRO is used, it is important for all parties involved to realize that providing a surviving spouse benefit to the alternate payee can result in the alternate payee receiving a larger share of the plan benefit than would be the case under a shared interest QORO that provides a surviving spouse benefit to the alternate payee.

Suppose a plan provides a QPSA that provides Mary, a surviving spouse, with 50% of the benefit provided to Joe, the participant, and that Joe is subject to a QORO that provides 50% of his benefit to the alternate payee, Mary. Under a shared interest QDRO, Mary receives no payments until Joe commences payment, unless Joe dies before then. If a shared interest QDRO provides that Mary (the alternate payee) is the surviving spouse for purposes of the QPSA, Mary will receive 50% of Joe’s benefit if he dies before commencing payment.

But contrast this result with a scenario involving a separate interest QDRO, which assigns 50% of Joe’s benefit to Mary (the alternate payee) that is paid to Mary whether or not Joe, the participant, dies. If the separate interest QDRO provides that Mary is the surviving spouse for purposes of the QPSA and Joe dies before commencing benefits, Mary will additionally receive 50% of the 50% Joe’s benefit not assigned to her, allowing her to receive roughly 75% of the benefit. This is problematic.

If the QDRO provides that for purposes of the qualified joint-and-survivor annuity (QJSA) the alternate payee (Mary) is the surviving spouse and suppose the plan’s surviving spouse’s annuity is 50% of the participant’s benefit payment then under the shared interest QDRO, Mary (the alternate payee) continues to receive 50% of Joe’s benefit if he dies after commencing benefits. Whereas, under the separate interest QDRO, Mary would additionally receive 50% of the 50% of Joe’s benefit not assigned to the alternate payee (Mary), thereby yet again allowing Mary to receive roughly 75% of the benefit. Yet again, a problem.

A shared interest QDRO will usually provide that the alternate payee is the surviving spouse for both the QPSA and the QJSA. A separate interest QORO will usually not provide that the alternate payee is the surviving spouse for both the QPSA and the QJSA, although certainly some alternate payees are able to negotiate that result. The distinction between shared and separate interest QDROs can get blurred by attorneys.¹⁸

Determining Benefit Amounts During the Split Calculation

An allocation method is generally used to determine how the benefit earned during the marriage (marital property) is calculated before it is split. A plan administrator will have to answer basic questions before beginning the allocation method: (a) What if the parties married prior to the conversion? Determining the equitable distribution becomes more complicated when a balance already exists at the time of the marriage. The statutory code of most states mandate that both appreciation acquired from separate property by one spouse during the marriage and any passive income is separate property. (b) What is the form of award to the alternate payee (percentage or dollar amount)?¹⁹ A new cash balance plan is the first retirement plan the company has ever had, while many other companies have converted their traditional defined benefit plan into a cash balance plan. (c) If the alternate payee dies prior to commencement of benefits, what happens to his/her share?

There are two main approaches to handling these issues: direct tracing and the fractional rule. If the plan is a pure cash balance plan (a cash balance plan that has only a cash balance formula and was initially established without converting an existing plan), direct tracing or the fractional rule can be applied to the hypothetical account balance, much as the rules would be applied to a participant’s individual account in a 401(k) plan. In fact, that would be the preferred approach for a pure cash balance plan. But, of course, many cash balance plans have formulas other than pure cash balance to contend with.

Direct Tracing

When a QDRO uses the direct tracing approach, the marital property is calculated as the benefit that accrued during the allocation period. This generally means calculating the increase in the accrued benefit from the date of marriage to the date of divorce.

The direct tracing method usually implies that the plan provisions and participant data (pay, service, etc.) that are in place at time of the QDRO are used to determine the benefit of the alternate payee. In other words, the alternate payee’s benefit would be based on a calculation of the benefit as though the participant terminated on the date of divorce. As such, the alternate payee will not be affected by any future plan amendments. Tracing separate property’s passive growth can be accomplished many ways. For example, if the investment vehicles are mutual funds and the record of exchanges and transfers is clear, tracing the growth of the premarital account balance with Morningstar’s Principia Pro software program can be a relatively straightforward process. At times, the company has offered yearly rates of return for various non–mutual fund investments evidenced by a detailed record of the transactions. While not as accurate as tracing monthly transfers, it is a reasonable alternative.

Fractional Rule

Under this approach, the marital property is calculated as a fraction of the participant’s benefit at his or her retirement. The fraction can be based on any reasonable time period comparison, such as service or participation where the numerator is the value of this measurement during the marriage and the denominator is the value of this measurement at the participant’s retirement. This method usually implies that the plan provisions and participant data (pay, service, etc.) in place at the time of the participant’s retirement are used to determine the marital property. In this case, the alternate payee’s benefit would be affected by any future plan amendments (unless the QDRO provided otherwise).

Analysis Under Both Methods

Consider a participant, Joe, who works for ACME Co. from age 25 to age 55 and then retires with 30 years of service. Joe was married to Mary for 10 years from age 30 to age 40. Joe and Mary are the same age. Suppose Joe accrued his benefit in the following manner:

Benefit at age 40 = $1,000 per month (payable at age 55 as single life annuity)

Benefit at age 55 = $4,000 per month (payable at age 55 as single life annuity)

A QDRO is in place that apportions 50% of the benefit to Mary. The calculation of her benefit under both the direct tracing and fractional rule approaches would be as follows:

Under direct tracing, the plan administrator would only need to look at the $1,000 per month benefit at age 40 to calculate Mary’s benefit. Assuming the QDRO splits the benefit based on years of marriage, the benefit would be calculated as follows:

Benefit at divorce: $1,000

Years of service at divorce: 15

Years of marriage while Joe accrued benefits: 10

Portion of benefit attributable to marriage: $1,000 × 10/15 = $666

Mary’s benefit (50%): $333 per month

If the fractional rule is used to calculate the benefit, the plan administrator would look at the benefit at retirement ($4,000 per month) to calculate Mary’s benefit. Assuming the QDRO splits the benefit based on years of marriage, the benefit would be calculated as follows:

Benefit at retirement: $4,000

Years of service at retirement: 30

Years of marriage while Joe accrued benefits: 10

Portion of benefit attributable to marriage: $4,000 × 10/30 = $1,334

Mary’s benefit: $667 per month

Determining Benefits Dependent on Age and Service Requirements

Benefits dependent on age and service requirements are handled in two primary ways:

Immediate Termination Approach wherein the eligibility for age/service based benefits is based on the assumption that the participant terminated on the date of divorce.

Continued Employment Approach wherein eligibility for age/service based benefits is based on the participant’s continued employment.

Suppose ACME plan requires Joe to have 15 years of service to be eligible for an early retirement supplement. However, on the date of divorce, Joe had 13 years of service. Joe then continues to work for another 8 years before retiring. Under the immediate termination approach, Mary (the alternate payee) would never be entitled to the supplement, because the participant lacked 15 years of service on the date of divorce. Under the continued employment approach, the supplement would be shared with Mary since Joe qualified for it by retiring with more than 15 years of service.

Keep in mind that there is no requirement that either the direct tracing or the fractional rule method be used with either the immediate termination or continued employment approach. This is based on the terms of the QDRO. However, to make a QDRO easier to administer and to understand, it is most common to link a method and approach as follows:

Direct tracing with the immediate termination approach, or Fractional rule with the continued employment approach

Using these pairings, either the entire calculation is based on Joe’s situation at the time of divorce, or everything is based on Joe’s situation at retirement. Most model QDRO language used by plan administrators would be based on these pairings since cash balance plans can calculate the benefit in a manner very similar to a defined contribution plan. Many participants therefore adopt a consistent approach to split benefits in their cash balance plan and 401(k) plan. Defined contribution plan QDROs generally split the current account balance at the time of the divorce, although some carve out the participant’s balance at the date of marriage and some carve out the contributions at the date of marriage plus subsequent earnings (or losses) on those contributions. A similar approach may be applied to the cash balance benefit under a plan.

Alternatively, cash balance plans usually allow for the benefit to be paid immediately as a lump sum on termination at any age. This can prove a very attractive option to alternate payees, as it disconnects them entirely from their former spouse’s employer. To facilitate payment of an immediate lump sum, the QDRO needs to allow for calculation of the benefit immediately following the divorce.

Another key factor for the alternate payee to actively seek a lump sum payment is the accrual pattern of cash balance plans. In a cash balance plan, the benefit accrues more levelly than for traditional defined benefit plans. This is true even for cash balance plans that vary pay credits by age, service or points (age plus service). In part, this is because the benefit due to past service under a cash balance plan does not increase when future pay increases, unlike a traditional final average pay plan. This cash balance characteristic reduces the value to the alternate payee of basing a QDRO benefit on a portion of the participant’s ultimate retirement benefit relative to the desire to receive a benefit immediately (at the time of the QDRO). Additionally, cash balance plans usually do not have early retirement subsidies built into the formula. Since there is no enhanced benefit to grow into, there is less reason for an alternate payee to desire a future retirement benefit over an immediate lump sum.

If the cash balance plan bases (increasing) pay credits on the age, service or points of the participant in a given year, an alternate payee may perceive greater value of a future benefit, and potentially want to base the benefit on the fractional rule. However, this can be more perception than reality when many cash balance plans apply relatively low interest credits (such as interest credits based on Treasury bond yields). Usually, the better option is for the alternate payee could take a lump sum, roll over the lump sum to an IRA and obtain a higher rate of return that more than offsets the plan’s interest crediting and higher pay credits for future years.

Other Features of Cash Balance Plans to Consider in Administering a QDRO

Cash balance plans often provide for richer preretirement death benefits than traditional defined benefit plans, whereas most traditional defined benefit plans provide only the basic legally required preretirement death benefit, which usually amounts to 50% of the value of the total benefit. Cash balance plans usually pay the entire account balance to a participant’s beneficiaries if the participant dies before receiving benefits. This feature should be considered to ensure that the participant and alternate payee knowingly agree on how to split the value of this feature.

Most cash balance plan QDROs split the account balance of the participant at the time of the divorce, such that the alternate payee’s benefit is paid out or maintained as a separate benefit within the plan. Unless the alternate payee and participant knowingly agree to additionally provide the alternate payee with a preretirement death benefit out of the participant’s remaining benefit, the payment of a death benefit to the alternate payee when the participant dies may be inequitable.

Conclusion

By law, the plan administrator determines whether a domestic relations order is a QDRO. Plans are required to have in place reasonable, delineated procedures to determine the qualified status of domestic relations orders, and the plan administrator must then follow these procedures. Among other things, procedures should ensure timely, efficient and cost-effective qualification of QDROs.

The cash balance plan may have additional features that are attractive to the participant but not important to the alternate payee. These could include richer death benefits, lump-sum payment options or much faster accruals after age 65. Given that the participant could make a choice that is not in the best interests the alternate payee, the plan sponsor needs to decide the appropriate approach to communicating the change to alternate payees.

There is no single best way to divide a QDRO’s pension benefits. The preferred approach will depend on many factors, including the type of pension plan as well as the intentions of the parties’ endeavoring to divide those benefits. For instance, some divorcing couples may not want to retain the connection implicit in the shared payment, fractional rule and continued employment approaches.

Cash balance plans often come with an array of options that can cause difficulty when dealing with a QDRO. Intimate knowledge of the company’s plan is by far the best defense for avoiding difficulties with these types of plans. It cannot be stressed enough for a plan administrator to know the cash balance plan’s provisions and nuances. Know the Plan. Perceive the Sunflower.

Footnotes

Acknowledgements

The author, Emir Phillips (PhD student in Financial Services and Retirement Planning), wishes to acknowledge the financial support from New York Life Insurance Company, its beneficent shareholders and its Chairman, President and CEO Theodore A. Mathas, without whose exceedingly generous and continuing support of The American College and its PhD program this article would not have been made possible. The author would also like to thank the President of The American College, Dr. Robert R. Johnson, PhD, CFA CAIA and Christopher P. Woehrle, JD, LLM (Guardian/Deppe Chair in Pensions and Retirement Planning), for their insights and guidance both academically and personally.

Declaration of Conflicting Interests

The author declared no potential conflicts of interest with respect to the research, authorship, and/or publication of this article.

Funding

The author received no financial support for the research, authorship, and/or publication of this article

Notes

Author Biography

Emir Phillips, JD/MBA MSFS, ChFC, CLU, is a student in the PhD program in financial and retirement planning at the American College, Bryn Mawr, Pennsylvania. Emir has over two decades of professional experience in business. He is the founder of Wealth Directives, Inc., a California corporation specializing in estate planning, guaranteeing retirement income, and lifestyle protection. Emir is a native of New Orleans, Louisiana, where his parents settled after fleeing Cuba in 1962, and where he continues to maintain a home. Naturally, Emir is a lifelong – and finally rewarded –fan of the New Orleans Saints. He has lived in Santa Monica, California, for the past twenty years.