Lest we be perceived to be obsessed with how interest rates are affecting the market, here comes another post discussing interest rates; albeit in a different context.
Although they are a thinning herd, America still has a lot of defined benefit pensions. Those are the pensions where you don’t have money on deposit (as in IRA and 401K plans) but the participant earns the right to an annuity payment upon attaining retirement age. In the case of government and union sponsored plans we have written that many of these plans are risky because they are often underfunded. Put simply, the assets held don’t spin off enough income to pay all the recipients what they have been told they will get.
There are two ways to divide these plans in divorce. One is to secure a court order providing that the benefit will be divided when the plan enters pay status (ie., retirement age). Thus if the plan calls for $1,000 a month to be paid once the participant attains age 65, the court can direct that the pension plan divide the payments between the participant and his/her former spouse. The second method is called the immediate offset approach. Here, an actuary is employed to value the annuity based upon the participant-employee’s life expectancy. If the payment is $1,000 a month, a 65 year old male is expected to live 18.2 years and thus would receive roughly $216,000 over his average life expectancy. The actuary’s job is to turn that calculation into a present value based upon life expectancy and the time value of money. Using 5.25% as the rate the value is $140,000. Had you valued the same pension and applied a 3% rate the present value would have been $165,000. Thus, if the participant kept the entire pension, he would have to find another $70-80,000 or more to acquire a spouse’s interest in the present value.
The use of immediate offset declined in popularity in 2007-2008 when the economy hit the Great Recession and the Federal Reserve acted to drive down interest rates to historic lows, as a means to stimulate the economy. Lower rates make for higher present values when doing immediate offset and most observers thought that the Federal Reserve would let rates rise once the recession ended. Meanwhile, the rates never really did bounce back until the last few months. But today, a thirty year mortgage is going for 5.25%. So, interest is back and likely to stay for a while unless the economy itself cools. This means that in the near term, a pension buyout based on immediate offset of the present value could make sense.
Ironically, a second force in the market could also suggest that immediate offset is the place to go. As we have noted, defined benefit pensions are kind of financial dinosaurs born in a day when a solid portfolio would hold stocks like, GE, Ford, General Mills and Boeing. Although pension plans are technically different entities than the companies that sponsor them, many of those companies don’t want the hassle of managing the plans. We are seeing the plans being offloaded to be administered by money managers, including life insurance companies. Word is circulating that some of these new managers are pushing back if they are not satisfied with a court order intended to divide a pension. For several years now, we have seen money managers delay transmission of retirement money even when there is a court plan to do so. This can produce a kind of financial rugby where the ball squeezes out, but no one is firmly in possession of the retirement assets until the pension/plan manager agrees as to who should have possession.
It’s a wild world out there. Unemployment is back to the pre-pandemic record lows. Meanwhile the S&P 500 average is up 20% while interest rates have risen 40% since January and the gross domestic product shrunk by 1.4% in the first quarter. How your individual asset portfolio should look as you go through a divorce is evaluated on a case by case basis. But after a decade when pensions were rarely considered for an immediate offset buyout, this option is now back and gaining momentum.