Ours is an age where hyperbole has not only become accepted, it is almost universally embraced as a part of American culture, and among the chief advocates of hype is the financial service sector of our economy. We lived throughout the 1980s, 1990s and early 2000s in an age when one could not open a newspaper or magazine without reading the amazing returns on investment that could be achieved by investing with this fund or that. In 2008, when the stock market imploded there was some respite from this enfilade of data on returns. However, as the traditional mutual funds were beaten into retreat, they were quickly replaced by a new creature; the hedge fund. These new investment vehicles promised a faster, better, ride because they would trade with and, when right, against the market. Money fled to these funds despite some enormous loads and aggressive profit sharing demands on the part of the smart guys who established them.

2016 was a watershed. The Dow Jones index grew by 15%; the S&P 500 by 11% and the NASDAQ kept pace at 11%. Meanwhile Barclays Hedge Fund Index barely cracked 6% in a world where the “house” routinely takes 2% up front and 20% of performance. So the 6% hedge fund yield was probably closer to 4%. The three-year average for the Barclays is a measly 3%, making even Treasuries look attractive.

These are the elements of the market that get the hype. And they all have teams of public relations and advertising officials to spin the story their way. However, today’s big news comes from the seldom-heard giants of the investment industry; the defined benefit pension managers. They don’t advertise. In fact, they don’t take customer’s investments. They take public employee retirement contributions and are charged with the duty to make certain the government’s promise to pay monthly retirement payments are actuarially sound.

Today’s news is from CALPERS, the largest public employee pension fund in America. This California agency and its analogues throughout the US manage $3.7 trillion in funds. Their customers are governments that have promised retirees a specified payment every month for life. If they cannot meet their projections, they have to demand that state and local governments pony up larger tax payments to fill the gap. And those governments are already screaming at the large percentage of government budgets allocated to covering pension costs.

So what are the big boys saying? In California’s case, they expect annual returns averaging 6.2% for the next decade. Some years will be better, some worse as the projection is an average. After 10 years, they see returns moving back up towards 8%, but the lower returns in the short run will mean more stress on your local governments to increase taxes.

The Ohio Public Employees system has predictions not much different. 6.76% over the next 5-7 years but then a bounce back towards the 8% that California predicts. Canada and Europe in the past years had lowered their expected returns while the US pension plans retained more flowery predictions. The US plans did not anticipate how far and how long interest rates would crater. The long-term prognosis for higher overall rates of return is premised in large part on a gradual return to historic interest rates.

For public employees, the concern about underfunded defined benefit plans remains. Low rates of return in the past several years have a cascading effect because income projections were not met. The Rockefeller Institute reports that the likelihood of a shortfall in income to distribute is 10x what it was 30 years ago. Subpar returns mean that CALPERS pays out more in benefits today than it receives in retirement contributions. We wrote about this looming problem in May 2016. Recently we spoke with Mark Altschuler who runs Pension Analysis Consultants in Elkins Park, PA. While actuaries, like Mark can project things like present value, it is not within their customary orbit to try to evaluate whether pensions will be able to meet their contractual undertakings to pay each beneficiary the prescribed amount on time.

What does this mean for the divorce practitioner and the client? When looking at the historic rates of return on S&P stocks between 1928 and 2014 the average rate of return today is approximately 10%. Some of that return is consumed by inflation. The other factor demanding consideration is risk tolerance. In March 2000, the SP500 stood at 1,527. It did not return to that value until October 2007. It then fell by more than half and did not return to 1,527 until 2013. The only way to gird against these market fluctuations is to integrate investments in stocks with investments in less volatile bonds. This is strategy that major government pension and annuity managers must emulate. It is also a polestar for conservative money managers. The term “going for broke” can be a self-fulfilling prophecy in the world of investment. So while last year the S&P kicked out 11% and that is 1% more than the 1924-2014 historic average, it would be improvident to build a financial plan exclusively around indexed rates of return. If you choose to believe that kind of growth is sustainable on a long-term basis, we encourage you to read Robert Gordon’s Rise of American Growth (Princeton 2016). So, for the medium term, prepare for 6% returns and be thankful if you do better.

This is not a money management blog but what we increasingly find is that many divorce clients simply “trusted” that their resources would be sufficient to carry them through retirement. The great awakening comes when they discover they are now splitting what looked like a comfortable retirement and that their ability to make up for lost time has been lost amidst the sands of time.

So today, lawyers need to help clients be creative, and based on an article in the March 22 Wall Street Journal, there is reason to take a second look at a device invented a few years ago called the reverse mortgage. When first introduced, they were disparaged as a kind of sleight of hand trick. The number of them issued spiked just after the Great Recession but then eased off as the economy (or at least the stock markets) recovered.

A reverse mortgage is what it sounds like. You have equity in a home that is essentially a trapped asset. A reverse mortgage involves your pledge of that equity to a lender who gives you your own trapped money. The true economist would dismiss this as absurd. If you need cash out of your home, don’t pay anyone fees or anything else to tap it; just sell, downsize and take the cash from the settlement proceeds. That’s why economics is called the dismal science.

The problem with today’s older divorced couples is that they want everything to stay the same. Sure, it’s only you living in the house that once held three or four. But you like it, you like the neighborhood, and besides, moving means dealing with 30 years of accumulated things that you call treasures and your child dismiss as “crap” when they come for Thanksgiving.

I typically advise clients that they should at least consider downsizing. The response is the same. A longing look like I told them they need to put the dog down unless his health improves and either a testy “Maybe next year” or even more challenging “Must I?” In the end, we assess matters and give clients options. No pets have met their demise on my watch but I have told several clients that unless they reduce their housing costs in the near term, they may need to consider a shorter life.

Reverse mortgages can be a way to ease the pain. At their worst, people borrow them to speculate. This is pure foolishness. But the mortgage in reverse can be a very effective tool, especially to cover late life rainy days. The best example is a sustained down market. If you are retired and drawing $4000 a month while getting $2,000 in social security, when the market tumbled, your $4,000 is coming out of a measurable smaller pool. If you had $300,000 in retirement and drew $3,000 a month in January, 2008 you had  100 months of retirement assuming no increase in value and no inflation. Your draw was 1%. By late Fall, your $300,000 was now $150,000 which mean your pool had halved and your draws were 2% a month.  The market quickly shot back up to 11,000 but if the trough had been sustained and you didn’t halve your expenses, you were burning retirement fast.

If you had a line of credit associated with a reverse mortgage, you could have reduced the impact on your portfolio by drawing on your home equity. Then you would have had more on hand to ride the market back to some form of equilibrium even though your home equity would have been reduced. There was a time when home prices could be said to keep pace with the market. But that is not a recent trend. A tract home in the Philadelphia region with 3,000 square feet  sold in July, 2008 for $400,000. Six years later it sold for $420,000 and it today draws estimates for $410-425,000.  Had you known in Fall, 2008, you could have borrowed $100,000 in home equity; stuck it in a Dow index fund and today your $100,000 would be worth $251,000. But, alas, that would require speculation.

But there are good times to draw on home equity. You sit, happily in your crap filled house burning through $3,000 a month of retirement. The roofer tells you “It’s time for me to get $20,000.” That roof can come out of home equity much more readily than an investment portfolio because the house is not really gaining value.

Now for some of the trickier strategies; tricky but solid if done in the right way. You are on a fixed income. You have $300,000 in equity but $200,000 in mortgage debt. The monthly mortgage of $200,000 plus $600 a month in real estate taxes is really crimping your ability to see the grandkids. Why not take a reverse mortgage on the equity to service the real mortgage you owe. This cuts expenses while leaving your investment portfolio intact. Yes, your real estate portfolio is going to decline but that wealth right now is trapped in housing and not really increasing.

Another strategy. We are told that if you delay drawing on Social Security from ordinary retirement to age 70, the monthly benefit payable rises by 7% a year. That’s a pretty solid return and it’s guaranteed unless you conk out along the way. But, you may look at the pension and retirement money you now have and say, I can’t really make it to 70 without tapping my social security. Why not consider a reverse mortgage to fund the “gap” of payments you might otherwise get if you applied early or at normal retirement age.

Your employer lays you off in December 2015. Because you are not a kid it is going to take time to find a job, which means that your 2016 income will be low. Financial planners will suggest that the off-year is a prime time to convert a traditional IRA to a Roth because your income will be low. But you do still have to pay the tax on the conversion. Why not take that out of a reverse mortgage to cover the taxes.

Typically, reverse mortgage payments come without tax because the payment is not income but a reduction in home equity. You are effectively getting your own money. Federal regulations now make it so that a steep decline in home equity such that the amount you took out exceeds the equity does not open the door to liability on your part. So this is now a tool and not a toy. It can be abused but it has options that can make your retirement far more comfortable.

We were consulted recently by a personal representative of an estate concerning the decedent’s death beneficiary of his 401(K) retirement plan.  The decedent had married before ERISA became law, but executed a beneficiary form shortly afterward naming his then spouse.  Later he divorced that spouse with a property settlement agreement by which spouse waived all rights to his ERISA retirement.  The decree of divorce, naturally terminated her status as a spouse.  But the decedent never bothered to execute a beneficiary designation naming a substitute.  As the reader might suspect, decedent dies with his former wife’s name on the form he executed forty years earlier.

So, the personal representative (e.g., executor) makes claim on the pension as part of the decedent’s estate.  The surviving non-spouse intervenes to say “Not so fast, he named me.” Executor responds “You waived.”  Ex-wife says: “I waived the right to make a claim in an adverse proceeding, but decedent’s failure to act demonstrates that he intended to retain me as beneficiary since he knew of my waiver but never named anyone else including the estate.”

Our client had slightly different facts, but those recited above produced Kennedy v. Plan Administrator for DuPont Savings and Investment Plan, 555 U.S. 285.  The Supreme Court of the United States decided that case in 2009 and held that absent more, the failure to change beneficiary designations after divorce means the designations will remain effective despite the intervening severance of the marital relationship.  The Court’s unanimous ruling states succinctly that while ex-wife waived the right to claim benefits in an adversarial sense that waiver also afforded the decedent the right to name his estate or anyone else in substitution by completing a simple form.  His failure to do so must be given meaning in its own right, absent some document or instrument showing a different intent. Ironically, in this case, the decedent had named a different beneficiary for another ERISA qualified DuPont retirement plan.

Matter resolved, correct?  Well, the Estate of William Kensinger was not taking no as an answer. The facts were essentially the same as in Kennedy except that the Estate waited until the benefits were distributed and then sued to recover the funds on the theory that the waiver of interest in the property settlement was effective as a matter of contract law, even if it was not as a matter of federal pension law.  The District Court of New Jersey dismissed the suit, citing Kennedy, but the Third Circuit Court of Appeals reversed on the basis that Kennedy was intended to prevent pension plans from becoming adjudicators among retirement plan claimants. But it held that the once the plan was distributed, it was subject to claims. Estate of Kensinger v. URL, Inc. 674 F.3d 131 (3d Cir. 2012)

So, for now, the word to clients is, even if you do not draft an alternate estate plan, Pennsylvania law helps you by means of a statute holding that a divorce revokes testamentary provisions to someone who is rendered a former spouse by decree of divorce.  20 Pa.C.S. 2507.  But that protection does not extend to matters governed by federal law and ERISA based pensions are the creature of the Congress, not the General Assembly.  The corollary warning is to attorneys who need to tell their clients the importance of changing these designations where they are ERISA based.

 

I would like to highlight a recent victory by one of our outstanding New Jersey family law attorneys; Jennifer Millner, Esquire, a partner in our Princeton office, won an appeal to New Jersey’s Appellate division over an issue arising from valuation of a military pension. 

Because the Husband’s Air Force pension was based upon an accumulation of points based on his rank, there is an identifiable difference between the marital component of his pension at the time they entered into their Marital Settlement Agreement and the benefit he received based on the years of post-divorce employment and point accumulation he had due to subsequent promotions and post-divorce efforts.

The trial court applied a very straightforward coverture fraction to value the pension, however, on appeal, Ms. Millner, with the assistance of Robert Epstein, Esquire and Eliana Baer, Esquire, successfully argued for the application of a coverture fraction that recognizes the distinction between the marital and post-marital impact of the Husband’s employment. The Appellate Division “[agreed] with the [husband’s] statement that the active duty and reservist components of his earnings are discernable, as one can not only calculate the points earned through the two distinct periods of military service, but also obtain the demarcated salary for each rank held.”

Jennifer’s summary and links to additional information on this important victory case can be found at Fox Rothschild’s New Jersey Family Law Blog.