Valuing Defined Benefit Pensions

There are two main kinds of retirement plans: defined contribution plans (401(k) for example) and defined benefit plans. 

This article is about defined benefit plans, and how to value them. 

There is typically no question about how to value a defined contribution plan: you just look at the account balance. 

Valuing a defined benefit plan is another story. 

A defined benefit plan is a retirement benefit that pays an amount every month, starting at retirement, and continuing until the participant dies. Plans sometimes continue to pay out at some level until the participant’s spouse (or former spouse) passes away as well. 

Defined benefit plans are much less common than they used to be. This is primarily because employers were incurring unsustainably large obligations, as employees lived longer and longer, and so employers discontinued the defined benefit plans.  

But some entities do continue to offer defined benefit plans: primarily governments (including police and military) and educational institutions. 

Why value a pension plan? 

The parties in a divorce sometimes agree just to split the benefits when they are paid. In that case, the value of the plan is not so important.  

But sometimes the participant wants to keep the entire pension. Then you will want to know how much property to give the other party to even things up. 

To do that, one has to know the value of the pension.  

That’s when valuing the pension becomes important.  

What is the value of a pension plan? 

The value of the plan starts with the monthly benefit amount.

The amount of the pension’s monthly benefit payment is typically based on a formula that considers the participant’s salary, years of employment and retirement age.  

The present value of the stream of monthly benefits will depend on the amount of the benefit, the interest rate, any cost of living adjustments (COLA), and the number of years over which it is paid. 

Because the value depends on some things that are unknown – the number of years the person will live, sometimes the rate of inflation, and future interest rates – the best anyone can do is to make an educated guess. 

We make that guess using the current COLA rate, a current safe rate of return, and mortality tables. 

How to calculate the present value of a defined pension plan in Family Law Software 

The first step in calculating the value of a pension is to contact the plan administrator for information about the plan.

The two documents which are most helpful are the annual plan participant statement and the Summary Plan Description (SPD).  

From these documents, you should be able to learn the estimated benefit amount at retirement, the proposed benefit start date, and the date the participant began participating in the plan.  

In some plans you may also be able to obtain the percentage of compensation that accrues for each year of service and the formula for calculating the ultimate retirement benefit. This information is useful if you are trying to calculate the benefit amount yourself. 

You will also want to check if there are automatic annual cost of living adjustments to the plan benefits. 

To obtain a quick pension valuation in Family Law Software, just enter the participant’s date of birth, retirement age, benefit amount, and the date to value the plan.

The software will apply the discount rate from the 20-year U.S. Treasury bond and the RP-2014 Mortality Table (the most commonly-used table) to quickly determine the present value of the pension.  

To get a calculation that matches the situation exactly, you may modify the discount rate, incorporate a cost-of-living adjustment, and choose from among eight mortality tables.  

The software will calculate the present value of the plan, the coverture fraction, and the marital portion.   

The coverture fraction is the fraction of the plan that is marital property.

For example, if the participant worked two years before the marriage and eight years during the marriage, then the coverture fraction would be 80%.

The marital portion is simply the coverture fraction applied to the plan’s value.

The remainder of the plan (the other 20% in our example) is the participant’s separate property. There will be some separate property if the participant was covered under the plan either before the marriage or after the separation.

You can use Family Law Software to calculate the present value of almost any defined pension plan.  

What plans doesn’t the software cover? It does not cover plans with unusual features such as jumps or declines in benefits — other then via cost of living adjustments — during the payout period.

But the software does cover virtually all corporate, municipal, state, educational, and military plans. 

The value calculated by Family Law Software is actuarially accurate and should be substantially the same as the value from an outside valuation firm (assuming the same inputs). 

Want to see this all-in action? Check out our webinar on Pension Plans here: 

Helpful Resources:  

Family Law Software Power Webinar Pensions:  

How can I tell if my pension valuation is right with Family Law Software?: 

How do I enter a defined benefit pension in Family Law Software?: 

IRS Mortality Tables for Determining Present Value Under Defined Benefit Pension Plans

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