Wisconsin Lawyer
Vol. 79, No. 10, October 2006

When Lovebirds Split:
Dividing the Retirement Nest Egg at Divorce – Dividing Wisconsin Retirement System Benefits

by Scott L. Dennison

overnment is big business in Wisconsin. About one in 12 people working in this state is a public employee, and about one in six Wisconsin divorce cases requires division of Wisconsin Retirement System (WRS) benefits.

Family law attorneys handling these cases must help their clients decide whether to divide their WRS benefits by using a qualified domestic relations order (QDRO) or by including the benefits in the property settlement. To advise their clients lawyers need to understand WRS retirement benefits and QDROs, and to have some idea of the value of their client's pension under a QDRO. When a QDRO is not used, and WRS benefits are included as marital assets in the property settlement, this knowledge should enable attorneys to protect their clients from errors often made by nonattorney experts (or by other attorneys) regarding the appraised value of these benefits.

A Malpractice Scenario

Cathy and Dave divorced in 2006. Relying on her attorney's advice, Cathy accepted a cash settlement for her share of Dave's WRS pension. In order to calculate Cathy's settlement amount the attorneys agreed to use "double the employee's contributions" as the pension's asset value. Dave had $75,000 in contributions, so the after-tax value of his pension was set at 80 percent of $150,000, or $120,000, and Cathy received half of that amount as her share of the pension. She has invested this $60,000 toward her retirement in a low-risk investment yielding 5 percent interest, after taxes.

So far there is nothing unusual about this story. But fast-forward 20 years to 2026, when Cathy is age 62 and wants to retire. Her retirement nest egg is now more than $159,000. However, a friend who is knowledgeable about the WRS has shown Cathy that if she had let her share of the pension remain in the WRS by using a QDRO, she would now be retiring with a pension of more than $2,300 per month for life, and this amount would increase every year with dividends. The value of this pension to Cathy would be at least $360,000 after taxes - more than twice the $159,000 she has saved from her divorce settlement. Cathy is very upset about this, and has filed a malpractice suit against her former attorney, alleging that he failed to advise her of what her pension rights were potentially worth under a QDRO. If the lawsuit is decided in Cathy's favor, the attorney may be found liable for damages equal to the difference between $360,000 and $159,000 - or more than $200,000.

Does this scenario sound implausible? It isn't. Although attorneys are aware that the use of QDROs is fraught with malpractice issues, they are far less aware that there may be liabilities associated with not using a QDRO - or at least with not knowing enough about them to give their clients reasonable advice. The dollar value of a WRS pension under a QDRO is much greater than most people realize, and this can be true for other retirement plans as well.

Understanding pension plans is difficult, but is necessary to avoid their pitfalls. This article provides a practical knowledge of the WRS in three parts. Part 1 describes the WRS, explaining how its retirement benefits are defined under chapter 40 of the Wisconsin Statutes. Part 2 describes QDROs under the WRS, and Part 3 explains three costly errors often made in appraising the value of WRS benefits for divorce cases when a QDRO is not used. Part 1 is rather dry reading, but it is basic to understanding Parts 2 and 3. Readers already familiar with WRS benefits may want to skip Part 1 and refer to it as needed.

Part 1: Overview of the WRS

The WRS, which is administered by the state Department of Employee Trust Funds (DETF), has both defined contribution and defined benefit plan features. The WRS defined contribution plan is called its Money Purchase Plan, offering a Money Purchase Benefit that is financed by employee contributions with matching amounts contributed by the employers. The WRS defined benefit plan offers an alternative Formula Benefit that is a pension based on an employee's compensation and years of service. The WRS pays the larger of these two amounts of pension, with each retiree receiving a pension that initially equals the greater of the Money Purchase Benefit or the Formula Benefit.

The WRS recognizes four employee categories: general, protective with Social Security (police), protective without Social Security (firefighters), and executives and elected officials. Each group has its own contribution rate, Formula Benefit, and retirement ages. Ninety-one percent of WRS members are general employees, which includes most public school and University of Wisconsin employees.

The Money Purchase Plan

Each employee contributes a percentage of salary to the WRS (5 percent for general employees). The amount to which contributions accumulate depends on WRS investment earnings. A Money Purchase Benefit is determined at retirement, equal to whatever pension the employee's contributions plus an equal amount of employer contributions can buy, using money purchase rates based on an intentionally low 5 percent interest rate. The DETF and the WRS actuaries expect future investment returns to average at least 7.8 percent. The difference between actual return and the 5 percent interest basis for money purchase rates helps to pay for WRS "dividends" (explained below).

The Formula Benefit

The Formula Benefit is a pension that depends not on employee contributions but on a benefit formula. It is formulated this way:

Monthly Pension Amount =
X% per Year of Creditable Service
times Final Average Earnings (FAE)
times Early Retirement Factor (ERF)

"X%" in this formula depends on the employee category and whether years of Creditable Service occurred before or after year 2000. For general employees, X% is 1.765 percent for years of service before 2000 and 1.6 percent for service after 1999. The Final Average Earnings (FAE) is the average of an employee's highest three years of earnings - usually from the last three years worked. The Early Retirement Factor (ERF) is an adjustment factor that compensates the plan for expense incurred when an employee retires earlier than is considered "normal."

Normal and Early Retirement

Each employee group has a Normal Retirement Age (NRA) and an Early Retirement Age (ERA) when members may first retire. For general employees these ages are 65 and 55. Members retiring at their NRA are eligible for the full Formula Benefit, so the Early Retirement Factor used in the benefit formula is 1.00. For an early retirement, the full Formula Benefit is reduced by a percentage that depends on how many years early the member retires and on the member's years of Creditable Service. The ERF used in this case is a decimal fraction. The main things to know about early retirement adjustments are that 1) the older a person is at retirement, the less the Formula Benefit is reduced, and 2) more years of Creditable Service also means less of a reduction to the Formula Benefit - that is, a larger ERF would be used in either situation.

The Pension Initially Paid. A retiree's pension is initially the greater of the Money Purchase Benefit or the Formula Benefit (as reduced for early retirement).

Dividends

In most years, a dividend will increase retirees' pensions by some percentage. Dividends are generally permanent increases to pensions once they are given. Dividends are a form of inflation protection, similar to cost-of-living adjustments (COLAs) in Social Security and in some other retirement plans.

The WRS gave dividends averaging 4.78 percent in all but one of the years from 1995 to 2004, plus an extra 9.6 percent dividend in 2000. The DETF conservatively expects future dividends to average at least 2.67 percent - a level of dividends that increases a pension's value by up to 40 percent. For example, assuming 5 percent interest, a $1,000 pension payable to a 55-year-old woman is worth 39 percent more with 2.67 percent dividends, because they add $72,000 in additional present value to the no-dividends present value of $185,000.

The Annual Statement of Benefits

Each January the DETF sends WRS members an Annual Statement of Benefits. This is an attorney's main source of information regarding WRS benefits. The following example illustrates information from a benefit statement and explains the calculations involved.

Example 1: An attorney's client, Ann, is divorcing Bob, who is a general WRS employee. Ann and Bob are both age 45 when they divorce on Jan. 1, 2006. The following information is from Bob's Jan. 1, 2006 Annual Statement of Benefits.

Page 1: Creditable Service = 10.00 years (4.00 pre-2000 and 6.00 post-1999); Employee Contributions = $24,025.67

Page 2: Earnings: $45,000 (2005), $43,478 (2004), $42,008 (2003); Final Average Earnings = $3,624; Money Purchase Balance = $48,051.34

"Retirement Benefit Projections":

At 55: Monthly Money Purchase Benefit = $273*; Monthly Formula Benefit = $391*

At 65: Monthly Money Purchase Benefit = $338*; Monthly Formula Benefit = $603*

Footnote to these retirement benefit projections: *These monthly amounts are based on your current balances as of 1/1/2006, and assume that you have reached the retirement ages shown on that date.

Explanation of the Calculations:

FAE = Highest 3 years of earnings averaged over 36 months: $45,000 + $43,478 + $42,008 = $130,486, and $130,486 / 36 = $3,624.61

The Money Purchase Balance = 2 x Employee Contributions = $48,051.34.

The "Money Purchase Rate" is .00570 at age 55 and .00705 at age 65. Therefore, 1) The Money Purchase Benefit at 55 is $48,051.34 x .00570 = $273.89, and 2) The Money Purchase Benefit at 65 is $48,051.34 x .00705 = $338.76.

The Formula Benefit at Normal Retirement Age 65 is: 1) For pre-2000 service: 1.765% of $3,624.61 x 4.00 years = $255.90, plus 2) For post-1999 service: 1.6% of $3,624.61 x 6.00 years = $347.96. Thus, the Total Formula Benefit = $603.86.

With 10 years of service, the Formula Benefit is reduced 35.2% at Early Retirement Age 55: $603.86 reduced by 35.2% = $603.86 x (1-.352) = $603.86 x .648 = $391.30 (the Early Retirement Factor (ERF) used here is .648).

The calculation of the Formula Benefit earned to date, if taken at retirement age 55, can be summarized in the following form:

[1.765% x 4 years + 1.6% x 6 years] x $3,624.61 x .648 = $391.30 monthly pension

(The Legislative Fiscal Bureau has published an excellent illustration of calculating WRS benefits in its "Informational Paper 74," available on the Internet.¹)

The greater (not the total) of the Money Purchase and Formula Benefits is the pension to be paid. Thus, Bob's benefit statement estimates $391 ($391.30 rounded down) payable at age 55 and $603 ($603.86 rounded down) payable at age 65. Most pension experts appraise one of these two estimates from a benefit statement when a WRS pension is part of a property settlement. The age 55 benefit amount is most often used.

Consider the footnote to the Annual Statement of Benefits explaining these estimates: "These monthly amounts are based on your current balances as of 1/1/2006, and assume that you have reached the retirement ages shown on that date." This means that the Money Purchase Balance, Final Average Earnings, and Early Retirement Factor used to calculate these retirement benefit projections are each what they would be if Bob were already age 55 or 65 on Jan. 1, 2006. Thus, these estimated pension amounts are what Bob would receive at age 55 or 65 if he quit his job now and then waited until age 55 or 65 to retire (that is, to receive his pension) - provided that his current Money Purchase Balance would grow no more until then.

This interpretation of how much pension Bob has already earned is technically called his Accrued Benefit. This is contrasted with his Projected Benefit, which is how much pension would derive from (be imputed to) his 10 years of accrued service and his current employee contributions if he continued to work until age 55 or 65 and then retired. From the benefit formula (as summarized above) the future increases in Bob's Final Average Earnings and Early Retirement Factor between now and age 55 or 65 will both increase the amount of Formula Benefit eventually derived from his 10 years of marital Creditable Service. These two factors tend to increase his Projected Benefit as compared with his Accrued Benefit. Future growth of his marital employee contributions at interest also will increase his Money Purchase Benefit, which could also increase his Projected Benefit.

A Point of Law

These two interpretations of how much pension one has already earned, the Accrued Benefit versus the Projected Benefit, are at the heart of an important question of law that is handled differently among the states: Should a pension's value as a marital asset be found by appraising the Accrued Benefit or the Projected Benefit? In Wisconsin, the Accrued Benefit is generally appraised when a pension is to be included in the settlement of assets. This is what family law attorneys are most familiar with. However, the Projected Benefit is the basis for pensions paid to alternate payees under QDROs filed with the WRS. Many lawyers have not yet become sufficiently familiar with these QDROs to appreciate this distinction.

Given that the odds are 5-to-1 that Bob will work until age 55 or later, we may assume that he will work for at least 10 more years. If a QDRO were used to divide their marital benefits, then Ann would eventually receive a pension based on half of Bob's 10 years of service as of their divorce date, but on a projected basis - that is, Bob's future increase in Final Average Earnings and Early Retirement Factor, as well as the future growth of Ann's half of their marital employee contributions, would all be factored into the calculation of Ann's pension when she retired as alternate payee under a QDRO.

Figure 1 Comparison of Bob and Ann's Accrued Benefits with Their Projected Marital Benefits Payable (to Them in Total) Under a QDRO.
	They Retire at Age "R"	55	62	65
1/1/2006 Benefit Statment	Accrued Benefit	$391	546	603
	Present Value(B)	$35,510	27,479	23,178
Their Projected "Marital Benefits"(A)	Money Purchase	$580	1,127	1,521
	FAE	$4,894	6,019	6,578
	ERF	.7760	.9556	1.000
	Formula Benefit	$633	988	1,096
	Projected Benefit	$633	1,127	1,521
	Present Value(B)	$57,421	56,714	58,399
Notes (A) Money Purchase Benefit = 2 x $24,026 x 1.078R-45 x Money Purchase Factor. This reflects the standard assumed 7.8% future rate of return on invested assets. FAE (Final Average Earnings) is based on assuming future 3% annual salary increases. ERF (Early Retirement Factor) = 1 minus Percent of Early Retirement Reduction. Formula Benefit = (.01765 x 4.00 + .016 x 6.00) x FAE x ERF. (B) Present values are as of 1/1/2006 and are net of an assumed 20% due for income taxes (15% federal and 5% state tax rates). Present values are based on these actuarial assumptions: 6% interest, 2.67% annual dividends (post-retirement pension increases), and WRS mortality rates for males. The valuation method uses exact actuarial calculations, with interest-only discounting from retirement age R to age 45, in order to include the value of preretirement death benefits in these present values.

In Part 2, the mechanics of a Wisconsin Retirement System QDRO are explained, and the values of this couple's Accrued Benefit and Projected Benefit are compared in Figure 1. You will see that the Accrued Benefit as reported on Bob's benefit statement is not a good estimate of the marital pension that Bob and Ann would end up dividing under a QDRO, and also that Ann's pension under a QDRO probably would be almost twice as valuable to her as the cash settlement she could expect to receive for the pension if a QDRO was not used.

Part 2: WRS Qualified Domestic Relations Orders

Under a QDRO, the alternate payee receives a specified percentage (up to 50 percent) of the WRS member's Employee Contributions Account and Creditable Service as of the date of divorce. Creditable Service is used for three purposes under the WRS: 1) to determine eligibility for certain benefit rights (for example, health insurance); 2) to calculate the Early Retirement Factor; and 3) in the benefit formula to determine the amount of Formula Benefit. Creditable Service is lost to the WRS member only as it is used in the benefit formula.

This statement appears in the DETF's brochure "How Divorce Can Affect Your WRS Benefits":

"The participant's future eligibility for benefit rights that are available only after earning a specified number of years of service is determined as though the participant's service was not reduced through a QDRO."²

For determining early retirement reductions, both the member and the alternate payee are treated as if each had all of the member's Creditable Service, marital and postmarital, up to the time of their retirements. Also, the alternate payee's Formula Benefit is computed using the member's Final Average Earnings computed when the alternate payee retires, not as of the date of divorce.

The Alternate Payee's Money Purchase Benefit

After the divorce, the alternate payee's share of employee contributions continues to grow with investment earnings, giving the alternate payee a larger Money Purchase Benefit when he or she retires than he or she would have been credited with at the date of divorce.

The Alternate Payee's Formula Benefit

The alternate payee's Formula Benefit will never be based on more Creditable Service than he or she received under the QDRO (usually 50 percent of the marital service). However, if the ex-spouse remains in WRS employment, the alternate payee's Formula Benefit will be greater at retirement than the Accrued Benefit at the time of divorce for two reasons:

1) The Final Average Earnings used in the benefit formula for the alternate payee continues to increase as the ex-spouse's salary increases. In the DETF's words:

"The [WRS] participant's FAE is not affected by a QDRO. His/her formula retirement benefits are based on the actual FAE at the time that the participant's benefit begins. The alternate payee's formula retirement benefits also are based on the participant's actual FAE at the time the alternate payee's retirement benefit begins."³

2) If the alternate payee retires early, less reduction will apply to the alternate payee's Formula Benefit as the ex-spouse continues to earn more years of Creditable Service.

"The [alternate payee's] age reduction factor is calculated based on the years of service the participant [ex-spouse] would have accrued at the time the alternate payee's benefit begins as though the participant's [ex-spouse's] credited service had never been reduced by a QDRO."⁴

Example 2: To illustrate these principles, calculate Ann's pension as alternate payee under a QDRO if Bob continues to work at least until age 55 and Ann retires at age 55. Under a QDRO, Ann receives 50 percent of their employee contributions, or $12,013. Assume that this increases to $25,458 by her age 55. Double this amount to allow for the employer's contribution, and convert the total to a Money Purchase Benefit:

Ann's Money Purchase Benefit = 2 x $25,458 x .00570 = $290.22 per month. (This is Ann's half of the $580 Money Purchase Benefit shown in Figure 1 below.)

Under a QDRO, Ann receives half of their 10 years of marital Creditable Service, which is two years of pre-2000 service plus three years of post-1999 service. Suppose that Bob's Final Average Earnings has increased to $4,894.33 by the time Ann retires. They would have 20 years of Creditable Service if not for the divorce, and all 20 years count toward improving their Early Retirement Factors. Based on all 20 years, their ERF at retirement age 55 has increased from .648 (used in Example 1) to .776. Therefore, Ann's Formula Benefit would initially be:

[.01765 x 2 years + .016 x 3 years] x $4,894.33 x .776 = $316.37 per month. (This is Ann's half of the $633 Formula Benefit shown in Figure 1.)

Ann's Formula Benefit exceeds her Money Purchase Benefit, so her pension as alternate payee under the QDRO will be the Formula Benefit amount of $316.37 per month.

This is Ann's half of their Projected Benefit, payable under a QDRO. This is much larger than her half of their $391.30 Accrued Benefit indicated on Bob's benefit statement - that is, $316.37 (Projected) versus $195.65 (Accrued).

The Value of a WRS Pension Under a QDRO

Now examine the value of Bob and Ann's combined marital pension received under a QDRO.

They were both age 45 when they divorced on Jan. 1, 2006, and we assume that Bob remains in WRS employment until he retires and that they will both retire at the same age. Define their Marital Benefits to mean those that derive from their marital employee contributions ($24,026) and Creditable Service (10 years). Figure 1 compares the Accrued Benefit amounts from Bob's benefit statement with their projected Marital Benefits at retirement ages 55, 62, and 65, and also shows the present value on Jan. 1, 2006, of each pension considered.

Although age 62 is not illustrated in benefit statements, it is the age at which most general employees tend to retire. Thus, 62 is the most meaningful age to use for illustrating Projected Benefits. The $546 Accrued Benefit shown in Figure 1 at age 62 is calculated in the same way as the amounts shown in Bob's benefit statement for ages 55 and 65.

Under a QDRO, Ann and Bob each receive half of their Marital Benefits. At age 62 this is an estimated $563 per month (half of $1,127). A QDRO appears to be better for Ann than a cash settlement, since at expected retirement age 62 the estimated $563 pension she would receive is presently worth about $32,381. This is more than half of the $56,714 shown in Figure 1, because the Figure 1 values are estimated using male mortality rates, and females tend to live longer and thus have higher present values for the same pension. $32,381 is about 82 percent more than the $17,755 (half of $35,510) that Ann probably would receive as a settlement for the pension. Since the future rate of return for the Money Purchase Account is likely to be higher than the 7.8 percent assumed in Figure 1, a QDRO may do even better for Ann than Figure 1 suggests.

If they use a QDRO, Bob's share of the projected Marital Benefits will equal Ann's share, but with a lower present value because of males' shorter life expectancy. If Bob retires at age 62, the present value of his estimated $563 per month would be half of $56,714, or $28,357.

Two important principles are illustrated in Figure 1:

1) The appraised present value of an Accrued Benefit is much larger when retirement age 55 is assumed than it is for later ages. Although the most realistic expectation is retirement at age 62, most WRS appraisals use age 55, when the Accrued Benefit is most valuable.

2) The present value of benefits under a QDRO is nearly the same at any retirement age.

This second observation leads to two simple formulas, as shown in Figure 2, that attorneys can use to estimate the value of an alternate payee's pension under a QDRO. (This present value is net of 20 percent income taxes.)

Figure 2 Formulas for Estimating the Present Value of an Alternate Payee's WRS Pension Under a QDRO

If the alternate payee is a ... Man: PV = 0.89 x Marital Employee Contributions x 1.017 N Woman: PV = 1.01 x Marital Employee Contributions x 1.017 N (The exponent N is the number of years from divorce until age 62.) Note: These present values are based on an assumed 6% interest (discount) rate.

The female version of the formula in Figure 2 gives $32,319 as the present value of Ann's after-tax pension under a QDRO. This is a very good estimate, since the more exact value is $32,381.

Part 3: Three Common Errors Found in WRS Appraisals

Attorneys should be alert to three errors often made in appraisals of WRS benefits.

1) Obsolete Data. The first error is failing to update estimated pensions from the date of the last benefit statement to the date of divorce. Many attorneys let this go unchallenged. However, updating a benefit statement's information to the divorce date is fairly straightforward, and it typically increases the pension recognized for divorce settlements by 5 percent to 20 percent. It is, after all, the pension at the date of divorce and not as of some earlier date that is the marital property.

2) No dividends? Experts appraising WRS benefits often omit the value of WRS post-retirement pension increases from their calculations. Because of the high value of dividends and the near certainty that they will occur, this is a substantial error. For example, the $35,510 in Figure 1 would have been only $26,853 if dividends had been overlooked. If Ann and Bob had settled in cash for their pension, this error could have cost Ann more than $4,000.

If the expert appraising a WRS pension uses a method based on the member's life expectancy (as most certified public accountants and many others do), then the interest ("discount") rate should be reduced by about 2.67 percent for finding the pension's present value at the retirement age. If no such reduction is made to the interest rate in a calculation based on life expectancy, then dividends were overlooked.

3) Double the Contributions? "Double the employee contributions" is a popular shortcut used by many attorneys to estimate the value of a WRS pension. It is understandable that attorneys do so, since the Money Purchase Benefit supposedly is the pension that double an employee's contributions will buy. However, this generally is not the correct value of a WRS pension for these reasons:

a) When the Formula Benefit exceeds the Money Purchase Benefit, then the Formula Benefit, not the Money Purchase Benefit, is the pension that is payable and should be appraised. "Double the contributions" is irrelevant to the Formula Benefit.

b) When the Money Purchase Benefit is the accrued pension to be appraised, double the contributions would be the present value if WRS Money Purchase Rates were calculated taking dividends into account, and if no other considerations were relevant in calculating present values. However, the Money Purchase Benefit does not contemplate dividends, and there are other technical factors as well that make "double the contributions" a poor appraisal method.

Sometimes this shortcut does come close to the correct present value of WRS Accrued Benefits, as for Bob and Ann, in whose situation "double the contributions" gives an appraisal that is only 8 percent off the mark. But in many cases this approach gives a very poor estimate of a pension's value.

Conclusion

Four things make the Wisconsin Retirement System more challenging to deal with than most pension plans. The first two are structural in nature, the third is an interesting point of Wisconsin law, and the fourth is a regrettable situation that education can improve.

1) It is a complex hybrid plan, combining the features of two types of retirement plan, Money Purchase and Formula Benefit. It also has different rules for different classes of employee.

2) It provides automatic increases (dividends) to retirees' pensions, which greatly increases their value - and the difficulty in appraising these pensions.

3) Under the WRS, QDROs preserve the full potential value, as if no divorce had occurred, of an ex-spouse's community interest in the pension by paying the Projected Benefit, rather than the Accrued Benefit - whereas only the value of the Accrued Benefit is considered when a pension is divided as part of a marital asset settlement. This is an interesting point of Wisconsin law.

4) Many pension experts on whom attorneys and the courts rely for guidance seem unaware of some or all of the three common errors described above - or of some other errors, for that matter. This is a regrettable situation that can be improved through education and by diligence on the part of attorneys, judges, and pension experts who do understand the issues addressed in this article.

Attorneys who understand the Wisconsin Retirement System are able to give their clients the best possible advice when WRS benefits must be divided in a divorce. This is in the best interest of both clients and attorneys: the clients are given invaluable assistance in a difficult situation and receive fair value for their community pension rights, and the attorneys avoid possible malpractice liability, while gaining the well-deserved reputation of being reliable counselors in this difficult area of law.

Endnotes

¹Legislative Fiscal Bureau, "Wisconsin Retirement System Informational Paper 74," at 57-60.

²"How Divorce Can Affect Your WRS Benefits," a brochure by the Department of Employee Trust Funds, in the section "Effects on Active/Inactive Accounts."

³Id., in the section "Effects on Active/Inactive Accounts" (emphasis added).

⁴Id., in the section "Benefits and Options Available to Alternate Payee."

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