by Jerry Reiss and Michael R. Walsh
Your opponent calls a “pension expert” to the stand to testify as to the present value of a marital pension benefit. Although you recognize errors in the expert’s testimony during direct examination, you may still have difficulty cross-examining that person. This article will attempt to demonstrate issues underlying proper pension valuation to assist with cross-examination. This article will show that the vast majority of persons used as experts fail to follow generally accepted pro-cedures necessary for rendering an expert opinion on pension valuation. Lastly, this article will illuminate mistakes made in the computational methodology. If these failures are properly understood, the practitioner may expose such persons as individuals -who are not experts and who do understand retirement plans.
Essential Criteria for Measuring Expertise
Qualified individuals in this area of law have a substantial background in and hands-on work with retirement plans. An in-quiry should first be made of the witness’ back-ground to determine if this person can justify his or her expertise. A careful detailed examination of the special train-ing and education should be made separate and apart from how many times the expert has testified in this court. Remember that pension expertise is a very specialized area and a person is not qualified merely because that person has a financial background.
While the level of an expert’s expertise can vary substan-tially, there are some standards of training that all attorneys should be familiar with in examining experts: “QPA” means quali-fied plan administrator, and “QPC” means qualified pension con-sultant. Both designations are awarded by the Society of Pension Actuaries.
The pension industry itself recognizes the actuary as the most qualified to render present value opinions. Typical actuarial designations include “FSA,” fellow of the Society of Actuaries; “ASA,” associate, Society of Actuaries; “MSPA,” mem-ber, Society of Pension Actuaries; “FSPA,” fellow, Society of Pension Actuaries; “EA,” enrolled actuary, licensed by Congress in ERISA;1 “FCA,” fellow of the Conference of Actuaries; and “MAAA,” member of the American Academy of Actuaries.
A good rule of thumb is to carefully scrutinize the expert about the present value calculation. Consider asking the expert to justify in detail why that person used certain assump-tions and how the present value result was obtained. The answer should support the present value methodology used.
Be careful about generalizations, particularly as to why a particular table was selected in rendering a present value opinion. The attorney should be cautious when the expert replies that the table is applicable because it is widely used by the government. This is an inappropriate response to the question. Every table has an intended use. The selection of appropriate assumptions is the subject of advanced actuarial work. This is why Congress licensed actuaries and limited the selection of assumptions to actuaries that are licensed under ERISA.2 There-fore, a true expert should be able to bore the court with volu-minous details of why that particular table was selected.
Testimony Confused by Terminology
The attorney should be familiar with appropriate use of valuation terminology. Courts are generally interested in a “fair market value.” Many experts claim that the present value of a retirement plan interest is its fair market value, but this is untrue. All retirement plans contain a nonassignment clause preventing the assignment or alienation of the benefit.3 As such, retirement plans cannot be sold or traded; therefore, they never have a fair market value!
Another source of confusion is to equate the term cash value with present value. When a perk has a cash value, it generally can
be traded in an open market. Existence of a cash value implies an employee’s right to demand a lump sum payment upon termination of employment equal to the monetary value. That entitlement generally exists with a 401(k) plan, but certainly does not exist in most other retirement plans.
A claim may be made that the present value represents the benefit worth. What a benefit may be worth, however, depends upon the perspective from which the present value is determined. The benefit may be worth an entirely different amount to an employer that funds it, than to a marital partner who wishes to share it. Thus, this distinction is very important, but often misunderstood. Consequently, attorneys should have the expert recognize and explain the distinction and valuation differences on cross-examination.
Another critical area of inquiry is to see if the expert used a life expectancy figure to calculate the present value result. This is the most serious error an expert can make and one that should alert the attorney that this person is not qualified to render an opinion.4 As the premise assumes that one lives a substantial number of years, ask the expert to reconcile the result with a participant who dies before receiving any benefit.
Additionally, it must be remembered that the husband and wife can have an entirely different perspective of benefit worth. This fact is often excluded by the “expert’s” own individual investigation, determination, and testimony. More often than not, however, there is confusion between the two, and as a result, it is a major stumbling block to counsel and the court in effecting such awards.5
The present value of the marital benefit must always be determined without respect to any particular personal or profes-sional point of view! For marital purposes, it should be based upon the benefit that the participant could receive and not any alternate form of benefit that the nonparticipant spouse might become eligible to receive under a QDRO.6 The present value must of necessity be based upon the participant’s lifetime. Thus, the expert under cross- examination should be required to distinguish between what the participant could receive from that which the participant may intend to receive. The former removes particip-ant discretionary control from the calculation. The latter does not.
To reiterate, the perspective for which the present value is sought drives the result. The same benefit can be worth varying amounts to different people and can be worth either greater or lesser amounts to the same person under different sets of circumstances. It depends upon the valuation perspective. If the benefit has an ascertainable market value, that value would be the same amount to everyone. Qualified experts understand the distinction between present value and market value.
The present value of a benefit is determined as of a specif-ic date. As such, it represents the value that may be received on that date, which is actuarially equivalent to some future lump sum amount, or some future periodic payment amount. As an actuarial equivalent, it also represents an amount of money that can be expected to grow sufficiently and replace the other future form of benefit. Any such expectation is based upon averages.7
In order to arrive at a present value, certain assumptions must be employed. Most attorneys understand that the foundation of the present value result depends upon the reasonableness of the assumptions made. What most fail to understand, however, is that what assumptions may be reasonable can also depend upon the point of view as to the person for whom the calculation is per-formed. Even the employer funding a defined benefit plan has to face this problem, and, accordingly, he or she asks the actuary to determine the present value from many different points of view.
One such difference is the contrast between the employer’s plan termination liability and employer’s accrued liability. To the lay person, this would appear to be the same thing, because either way, the same benefits must be provided in any event. Yet ERISA defines the distinction under 26 U.S.C. §417(e)(3).
To terminate a plan qualified under IRC §401(a), the present value of the benefit must be calculated using certain assumptions that vary with market conditions. If the employer can meet the liability using these assumptions, it will be permitted to termi-nate the plan. Often the employer can meet this liability at a fraction of the cost by not terminating the plan at all. Rather, the employer simply freezes future benefit accruals and pays the accrued benefits from the trust fund as they become due. If the employer later becomes insolvent or seeks to sell the business, it faces the necessity of terminating the plan.8 As a result, both values are meaningful for the same benefit and to the same employer.
Testimony on Defined Contribution Plans
A defined contribution plan defines the earned right to benefits as a specific amount of employer contribution in each year. However, no guarantees are made as to what will be avail-able at retirement. What is available at retirement depends upon future investment results. Contribution entitlement is customar-ily based upon hours of service worked in the year of contribu-tion, as well as the salary earned by the employee during the same period. The amount of employer contribution can even be related to the employee’s age and can depend upon a contribution that the employee may have made in the year. Which provisions may be applicable depend upon the plan in question. Thus, to be informed specifically requires that the pension expert read the entire plan document before rendering advice as to what was earned by the participant. What has been earned will also depend upon the plan’s valuation date, which is stated in the same materials.
When a retirement plan measures the employee’s rights to benefits as account balances, this figure often is used in place of the present value of the benefit. But question the expert about whether this is correct when some defined contribution plans will not make payment other than at some stated retirement date, and other plans will require the installment to be paid as a lifetime monthly benefit. No one questions that retirement benefits are valued on a current-day basis for defined benefit plans, by present-valuing the future benefits. Given this propo-sition, wouldn’t the same rule apply when the account balance is not available, except at retirement, or is never available be-cause of the plan’s requirement to convert the account balance to an annuity? Shouldn’t the present-day value of this benefit be determined by first projecting the account balance to the earli-est retirement date of the participant, using the higher invest-ment rate that the company can expect, but then discount that same projected value back, based upon a lower rate of interest that an individual with little funds could expect?
Another issue that can affect the amount of the marital present value of a defined contribution benefit relates to wheth-er it is reasonable to measure the property by assuming that the participant terminated employment on the measurement date when that did not occur.
Example: A participant has an account balance on 12/31/96 of $120,000. This money is participant-directed and provides a daily account balance. The plan’s sole valuation date is 12/31, meaning that this is also the only time that the employer makes the company contribution. The parties file for dissolution on 11/1/97. The 11/1/97 value of the 12/31/96 benefit is $130,000. Is it reasonable to use the account balance of $130,000 as the present value of the marital benefit?
Issues like these often are ignored because the “expert” must read the plan document first. Facts about the plan should be part of the expert’s testimony. Most self-proclaimed pension experts do not read the “contract/plan document” (which defines earnings) before offering an opinion.
If the plan requires the employee to work 1,000 hours in the year before any contribution will be made, and also provides that the amount of the contribution is to be based upon the amount of compensation that was earned in that year, what possible legal justification could there be for not adjusting the 11/1/97 ac-count balance for 10/12ths of the 12/31/97 contribution? First, it is arguably unlikely that any employee could possibly work 1,000 hours during the two-month nonmarital period that followed. Second, the earned amount of contribution that was spelled out in the plan is directly related to the amount of salary earned. To exclude the 10/12th component from the marital portion would be to base the nonmarital portion of contribution on salary that was mostly earned during the marital period.
Caution, however; the flip side of this issue is also equal-ly ignored. Modify the previous example to provide that the parties married on 11/1/96. For the exact same reason, not more than 2/12ths of the 12/31/96 contribution that was made during the marriage could be attributable to marital efforts. There-fore, the nonmarital portion is adjusted by increasing it by 10/12ths of the contribution made on 12/31/96.
A present value computation that is made without first reading the plan is a fundamental mistake, but one that is made routinely. By omitting to read it, no attempt is made to deter-mine the true nature of the benefit or what other benefits may be available, and what conditions might be attached to them. This is particularly true with defined benefit plans because extra perks, when available, are often more valuable than the basic benefit to be ascertained. This is why it is a significant error for an attorney to ignore the valuation process entirely when the par-ties intend to divide the benefit via a QDRO.9
Testimony on Defined Benefit Plans
A defined benefit plan defines and guarantees what benefits will be available at retirement. Some of the modern defined benefit plans can express these benefits in a form resembling a defined contribution plan, i.e., they can have account balances. This account balance is unrelated to market conditions. While the present value can be connected to that account balance, however, it can also be unrelated when the plan’s alternate form monthly benefit has a higher present value. Under such circumstances, the higher amount should be used. Furthermore, the account balance, which is defined by the plan, should be present-valued by discounting the projected benefit at retirement.
Poorly qualified pension experts have difficulty recognizing cash balance plans as defined benefit plans. Accordingly, they value the benefits as if they were earned under defined contribu-tion plans.
Most present value computations still center around tradi-tional defined benefit plans providing a monthly lifetime benefit at retirement. In order to arrive at a value, many assumptions must be utilized. Even when the assumptions that are used are reasonable, most family law practitioners or experts fail to understand that the computation is meaningful and accurate only as an actuarial value.
The distinction between an actuarial value and what most attorneys believe that the present value represents is that the present value of a single benefit is likely to be in error and the size of the error can be enormous. That result comes about because reasonable assumptions are based upon averages. Any one calculation can be off by a huge amount. Yet perform enough calculations and the individual errors offset one another for a large enough group. Hence, reasonable assumptions will produce very accurate results for pension funding purposes, where the liability of the whole group is at issue and the value of any one benefit is insignificant to the process. Accordingly, a present value of a benefit represents, at best, the most probable current value that the benefit has in place. It does not represent its actual value.
Essentially, most attorneys understand this concept, yet regularly accept nonactuary calculations based upon life expect-ancies. Calculating the benefit in this fashion assumes as fact the one result that is almost guaranteed to be in error: that the participant will live to the life expectancy and then die.
There is an even more significant error that is made by this methodology. Explicit life expectancy calculations are as complicated as explicit present value calculations.10 Where, then, did the nonactuary obtain the life expectancy11 result when no pension table provides this information?
If it came from a census table, as is frequently the case, then the present value computation measures the result with an individual life expectancy that includes the indigent, the work-ing poor who cannot afford health insurance, the terminally ill, the nonworking ill, and the incarcerated, all of whom possess a significantly lower life expectancy, on average, than a pension-er. Correct present value computations use appropriate pension tables and measure the value of each future monthly payment by discounting it to reflect the probability of its receipt.
Too many pension “experts” are completely unqualified to render a valuation opinion. Attorneys and the courts should be able to recognize an expert as unqualified when the expert has difficulty supporting the assumptions that were used with clear unequivocal answers, but instead uses other people or government agencies to justify its use. Each table was designed for a specific purpose. Unless that expert can explain that specific purpose, he or she really has no reason to support its use. Real experts do not use life expectancies to value retirement benefits. Qualified experts do not rely upon benefit statements because they understand their limited use. Instead, they know they must read a plan document, because that is the only legal instrument that defines the benefit rights of the participant. Qualified experts understand what a present value computation represents and what it does not. Proper valuation is an essential part of dividing marital property even when the benefit is divided by a QDRO.
1 ERISA §3042.
2 20 U.S.C. Ch. 8, §901. The governing regulations are found under 41 FR 2080 as amended by 42 FR 39200.
3 For plans subject to ERISA, see ERISA §206(d).
4 Wallace, Life Contingencies, Society of Actuaries 174–175 (2d Ed. 1967).
5 This is different from marital worth and should be determined from the participant’s point of view. When executing a buyout, the participant exchanges liquid assets for nonliquid assets. If the participant were to later become ill, the nonliquidity of the assets retained will become more meaningful. Therefore, a substantial discount of the marital present value may be justi-fied, if the surrounding facts support it.
6 Qualified Domestic Relations Order, see ERISA §206(d)(3).
7 The chances that anything is exactly realized is zero. Expectations only show the likeliest result based upon averages. Selby, CRC Standard Mathematical Tables, Student Ed., The Chemi-cal Rubber Co. 537 (16th Ed. 1968).
8 An insolvent employer faces an involuntary termination under ERISA §4044. If the plan is overfunded, it represents an asset on a sale of the business that the employer needs to recoup. If the plan is underfunded, few companies would consider buying the employer.
9 This was the only clear finding of the recent Supreme Court decision in Boyett v. Boyett, 703 So. 2d 451 (Fla. 1997).
10 The life expectancy at age “x” equals
Stpx, where tpx repre-sents the probability of a life “x” surviving to “t+x”.
11 Life expectancies are calculated by actuaries in order to compare the mortality trends of various tables. They have no other useful financial purpose.
As an associate, Society of Actuaries, and an enrolled actuary, Jerry Reiss has provided consulting and actuarial services to hundreds of plan administrators. Located in Altamonte Springs, he now concentrates in divorce, preparing QDROs, and actuarial valuations, and has written numerous articles. Mr. Reiss is listed in the expert national directory, American Academy of Matrimonial Attorneys.
Michael R. Walsh received his J.D. from Duke University in 1963. He practices in Orlando, is a board certified marital and family lawyer, certified mediator and arbitrator, fellow of the American Academy of Matrimonial Lawyers, and a frequent author and lecturer for The Florida Bar as well as other professional organizations.
This column is submitted on behalf of the Family Law Section, Deborah B. Marks, chair, and John Morse, editor.