How Does the Family Law Practitioner Properly Advise a Client in Divorce When One Party Participates in KTRS?

This blog post is based upon a topic I have researched over the past year, and am continuing to explore with the intention of ultimately submitting something more formal for publication.  This post follows my general blogging trend.  I present a problem – for instance, in this case arising from legislative and judicial ambiguity – and then submit to my reader a possible solution to chew on.  It is a longer post than usual, and is not for the faint at heart.  Venture at your own risk...

Recently, in Eden v. Eden, No. 2012-CA-000819-MR (Ky. App. 2014), the Kentucky Court of Appeals considered the proper classification and division of a Kentucky Teachers’ Retirement System Pension (“KTRS Plan” or “KTRS Pension”) in divorce pursuant to the governing statutes and regulations (see my blog post dated March 25, 2014).   Although not directly at issue in Eden, because the participant was already retired and drawing his monthly retirement allowance, this author could not help but to be reminded of the uncertainty under state law when valuing, classifying, and dividing a KTRS pension in divorce.

A little background first.  Established by the legislature in 1938, KTRS provides a Defined Benefit Group Retirement Plan to its membership.  There are several categories of mandatory membership, and agencies eligible for participation in KTRS include public elementary and secondary schools, regional educational cooperatives, several state universities, the Department of Education, and other agencies as specified by law.  KTRS currently serves over 75,000 active members, and over 45,000 annuitants.

KTRS is not subject to ERISA.  Rather, ERISA governs private employment sector retirement plans.  Accordingly, any reference to “QDRO” herein applies specifically to the term as it is defined under Kentucky law, not ERISA.  See KRS 161.220(25).  The KTRS Plan is, however, qualified under Section 401(a) of the Internal Revenue Code as a “defined benefit” plan.  Meaning, KTRS participants are eligible to draw a monthly retirement allowance for the rest of their lives that is based upon such factors as age, earnings, and service years.  Of significant note, the KTRS retirement allowance is not based upon how much was contributed by participants to their KTRS Pension during covered employment. 

An important distinction to make here at the get-go is that KTRS participants contribute a statutorily set percentage of their salary into their KTRS Plan from their first day of employment.  Upon termination of employment, these employee contributions (plus earned interest, less medical insurance fund deductions) can be refunded by KTRS to the member at the KTRS member’s voluntary election.  Employee contributions are a common component of many state and federal government pensions (as a means to help defray plans costs and bankroll death benefits, etc.).  However, the same is not true for private employer pensions; private sector pensions typically do not include employee contributions. 

For this reason, among others to be explored below, the KTRS Pension can be problematic in the context of divorce.  The proper method to value a KTRS Pension in divorce, particularly when the non-KTRS employed spouse has his/her own retirement plan that must be likewise valued to determine any offset as required by statute, remains an unresolved issue under Kentucky domestic relations law.  This presents a potential minefield for the family law practitioner – and the divorcing parties – when attempting to equitably divide martial property in divorce.

The world is full of obvious things which nobody by any chance ever observes.
~ Sherlock Holmes

So, what is the proper methodology for valuing a KTRS Pension in divorce?  This author tips her hat to Mark Ogle, Esq.  Hopefully you’ve been lucky enough to catch Mr. Ogle’s CLE presentation on the issue, aptly titled, “’It’s Elementary my Dear’ . . .  Or is It?” (A clever pun on the complications involved in valuing the KTRS Pension, much like some of the advanced-level mathematics taught in school by the very teachers protected by the KTRS Plan).  Mr. Ogle has had his finger on the pulse of this issue for some time as the Appellant’s attorney in Winstead v. Winstead, 2008-CA-002317-MR (Ky. App. 2008) (not published) (holding the actual cash value of the accounts—that is, the amount available for immediate withdrawal from each spouse’s retirement plan—to be the proper value to consider for division purposes). 

In Winstead, Appellant argued that the trial court erred in using the current ‘cash value’ of amounts immediately available from the Appellee’s KTRS Pension, resulting from her employee contributions, as a means to calculate the net present value of Appellee’s KTRS Pension.   Appellant urged that instead, the trial court should have utilized the ‘actuarial value’ method to calculate the net present value of Appellee’s KTRS Pension, in order to prevent the otherwise inequitable offset and division of his 401(k). 

The unresolved valuation issue was borne from a long history of preferred treatment for the KTRS Pension under state law.  Because of the unique fact that KTRS participants do not pay into Social Security, KTRS retirement assets were given complete exemption from their assignment and division as marital property in divorce.  (An excellent recount of the history of the KTRS Pension in divorce can be found in Shown v. Shown, 233 S.W.3d 719 (Ky. 2007)).  Thus, a KTRS spouse could have had an $8,000.00/month benefit that was entirely accrued during the marriage, but completely off limits to the non-KTRS spouse in divorce, even though the non-KTRS spouse’s twenty-thousand dollar 401(k) earned during the marriage was subject to a 50-50% split.  This was a seemingly harsh and arbitrary result. 

For brevity’s sake, suffice to say that over time, and through an interesting game of ping-pong between the judiciary and legislature, the final result is that KTRS Pensions continue to be exempt from being classified as marital property (see KRS 161.700(3)), but only to the extent as provided in KRS 403.190(4).  In other words, if the retirement benefits of one spouse are exempt from classification, such as a KTRS Pension pursuant to KRS 161.700(3), then the retirement benefits of the other spouse are exempt as well; however, neither spouse can enjoy a greater exemption than the other.  See KRS 403.190(4); see also Shown v. Shown, 233 S.W.3d 719 (Ky. 2007) (holding Husband’s KTRS pension was the larger asset, and as such, was divisible marital property to the extent it exceeded Wife’s SEP-IRA).

In a nutshell, for practical purposes, it comes down to this – the KTRS Pension continues to enjoy complete protection under statute when the non-KTRS spouse has no retirement assets of his/her own.  See Brooks v. Brooks, 350 S.W. 3d 823 (Ky. App. 2011) (holding that the non-KTRS spouse had no retirement assets, thus, KRS 403.190(4) was not triggered, and the entire KTRS account was exempted from classification as marital property pursuant to KRS 161.700(3)).  Incidentally, this means the non-KTRS spouse would come out better in a divorce if he/she had $5.00 in a 401(k), rather than having no retirement account at all, because by having the small retirement account, the non-KTRS spouse makes the balance of the KTRS Pension divisible under KRS 403.190(4).  In any case, if the non-KTRS spouse has a retirement asset of his/her own, then both spouses’ retirement assets come to the chopping block, pursuant to KRS 403.190(4), and once the ‘excess’ of the larger retirement asset is lopped off and divided, the intended result is that each spouse walks away with an equal apportionment of any retirement assets earned during the marriage (presuming a 50% distribution).

At the end of the day, when each spouse has a retirement asset in divorce, and one spouse is a KTRS member, the spouse with the greater retirement asset is going to end up sharing the excess marital portion thereof, either by offsetting the difference in value with other assets, or through the deferred distribution of the difference in value of the retirement accounts via QDRO.  Eden demonstrates how this might work (see my blog post dated March 25, 2014), wherein a portion of husband’s KTRS pension was considered martial, and thus was divided via QDRO, to the extent that his KTRS benefit was valued in excess of Wife’s non-KTRS retirement plan. 

Thus in divorce, anytime one spouse has an interest in a KTRS Pension and the other spouse has some other retirement asset of his/her own, the net present value of both retirement assets must first be determined for offset purposes to determine which account is going to be divided (or rather, which spouse is going to have to share the excess of his/her account with the other).  That is, the first thing that must be accomplished is the calculation of the current value of both parties’ marital retirement assets in order to determine which spouse has the greater marital retirement asset as of the date of divorce.  The second step would be the actual division of the ‘excess’ spouse’s retirement asset by “immediate offset” with other property, or by “deferred distribution” via QDRO.

That (finally) brings us to the heart of the issue:  What method of valuation should be used at the outset to determine the potential lump-sum net present value of the KTRS Pension?  The “cash-out value” of the refund of employee contributions available for immediate withdrawal, or the “actuarial value” of the lifetime service retirement allowance? 

Neither statute, Shown, nor any other case within the Commonwealth presents a universally approved method of valuing retirement assets for determining the statutorily exempted amount, if any, of a KTRS Pension.  As for now, the only rule of law guiding the practitioner is the well-settled (and sometimes annoying) principle that the trial court enjoys broad discretionary power in valuing and dividing retirement assets.  See Armstrong v. Armstrong, 34 S.W.3d 83, 85-86 (Ky. App. 2000).  Well... Great.

Parenthetically, outside of the context of KTRS, the present actuarial value of future stream of periodic payments is the accepted standard for valuing and converting pension assets into today’s dollars.  And for what it is worth, for the reasons set forth below, this author believes the actuarial value is most often the more appropriate valuation method to “offset” the value of a KTRS Plan against that of a non-KTRS spouse’s retirement plan. 

Employee Contributions Have No Bearing on the Total Service Retirement Allowance

The actual cash value of the accounts, or cash-out valuation method, is based solely upon amounts available for immediate withdrawal from the KTRS Pension, i.e., the return of employee contributions (statutorily referred to as the “refundable account balance” or “termination refund”, see 102 KAR 1:320).  That is, employee contributions only, and not including any employer contributions, or other employer-added benefits such as cost-of-living increases (COLAs) (see Winstead at FN2).  However, the KTRS employer contributions constitute the majority of the overall value of the total accrued KTRS Pension, and thus of the monthly KTRS Pension benefit as well.  For this reason, it seems illogical to consider the termination refund to be an appropriate representation of the KTRS Pension value.

To illustrate this point, imagine a case wherein a member’s KTRS termination refund balance as of the date of divorce totals approximately $50,000.00.  Yet the accrued monthly retirement allowance as of the date of divorce is $2,500.00 per month, payable for life.  Certainly the employee’s contribution of $50,000.00 could not be invested to pay $2,500.00 per month, or $30,000.00 per year, for the rest of his/her life, plus annual compounding COLAs of 1.5%.  It isn’t rocket science that employee contributions alone fall way short of the actual value of the retiree’s pension.

In fact, employee contributions have absolutely no bearing on the actual KTRS Pension or monthly benefit the member will receive at retirement.  Rather, a KTRS member’s “normal retirement age” monthly retirement allowance is based upon his/her 3-5 years average highest salary multiplied by years of creditable service, then multiplied by a percentage factor of 2-3%, and finally divided by 12.   Thus, the sensible method to determine the lump-sum net present value of a KTRS Pension is by calculating the actuarial value of the monthly retirement allowance, that is, the lump-sum current value of the participant’s lifetime stream of future monthly benefits.  This would generally be determined by the KTRS monthly retirement allowance to be paid at normal retirement age, as of the date of divorce, and the statistical life expectancy and mortality of the participant (this amount would then be discounted to represent today’s dollars). 

Apples to Apples:  The Court Must Establish an Level Playing Field

It is a misnomer to refer to the balance of KTRS employee contributions as a “cash-out value”.  Though in Winstead, the trial court did just that, treating the employee contribution balance as if it were some tangible amount immediately available to the KTRS participant.  However, a refund of employee contributions is only available to members upon permanent termination of their employment.  Further, once members are eligible for service retirement, by statute, the option to obtain such refund in most cases is taken off the table entirely and the member must elect the retirement allowance (monthly benefit).  Thus, in divorce, if the KTRS member is still actively employed, or is eligible for service retirement, the termination refund is not available for cash-out.  Moreover, even if it were, if the KTRS member is under 59 ½, the contributions will be subject to early withdrawal penalties. 

Regardless, assuming arguendo that there is a cash-out refund available for immediate withdrawal for the KTRS participant of his/her employee contributions, using the value of the refund – instead of the actuarial value of the future payment stream – would result in a panoply of incongruences and potential inequities, as detailed below. 

It is critical to understand that the KTRS service retirement allowance vests with the participant after five (5) years of creditable service. Vesting guarantees the member, as long as he/she does not elect to receive a refund of their employee contributions, a future monthly retirement allowance even if his/her employment in a KTRS covered position is discontinued and the he/she no longer contributes to the system.  The KTRS member can also elect to take a refund upon termination of employment, but later repay the refund, and after a year of re-employment service again be eligible for a retirement allowance as if the refund had never occurred.  Assuming that the KTRS Pension at issue is fully vested, if you accept the cash-out value of the KTRS employee contributions as the proper methodology to determine any offset between the KTRS Plan and non-KTRS plan under KRS 403.190(4), then the non-KTRS spouse will always be left to the mercy of the KTRS spouse.  In essence, the non-KTRS spouse, under any conceivable circumstance that this author can imagine, could be unfairly penalized by the unilateral decision-making power of the KTRS spouse (i.e., to take the refund, or not). 

Let’s make some comparisons to vet out my claim.  Suppose a case where one spouse is a member of KTRS, and the other is a participant in a private employer pension.  If the KTRS termination refund is used as the basis to determine which retirement asset is in excess, and thus subject to division, what would the correct method be to determine the value of the private pension for comparison?  The cash-out value of the private pension would be zero, since there are no employee contributions, as is generally the case with private plans.  If the actuarial value of the future stream of monthly payments is used to value the private pension, and the KTRS spouse does not elect a termination refund, the KTRS spouse will enjoy an excess lifetime retirement allowance that is unintended under the law.  In the former scenario, an obviously absurd result occurs to the detriment of the KTRS spouse, while the latter scenario results in a windfall for the KTRS spouse, if the KTRS spouse – at his/her sole discretion – decides not to forego his/her guaranteed entitlement to a retirement allowance (or elects a refund, and then becomes re-employed and re-eligible for a service retirement allowance).

If the comparison is to another state or federal government pension plan that requires employee contributions and allows for termination refunds, although the choice to elect a refund or an annuity is no longer unilateral, the results would always be subject to inequity based on an individual spouse’s election.

Conversely, in a case similar to Winstead, where a vested KTRS member’s termination refund is compared to the value of a 401(k) type plan, the inequity associated with utilizing the cash-out method to value the KTRS Pension has the potential to be downright brazen.  For instance, assume as of the date of divorce the KTRS spouse’s termination refund is valued at $16,000.00, and the current actuarial value of the future stream of monthly benefits is $90,000.00.  The other spouse’s 401(k) is valued at $70,000.00. 

If the KTRS termination refund is used to determine the statutory offset, that means the 401(k) spouse will have to divide the $54,000.00 ‘excess’ of her account.  The KTRS spouse will end up with $43,000.00 between his termination refund value of $16,000.00 and $27,000.00 from the 401(k) (assuming 50% of the $54,000.00 excess).  But KTRS spouse can, at his own design and sole discretion, simply elect not to take a refund (which he may not be allowed to do in any case, unless he terminates employment, or if he reaches service retirement eligibility).  Thus, the KTRS spouse will have not only the equivalent of $43,000.00 incident to the divorce, but also a vested right to receive his full monthly retirement allowance, even if he terminates his employment.  So, the KTRS spouse walks away with a full entitlement to his $90,000.00 pension benefit plus $27,000.00 from the 401(k), and the 401(k) spouse is left with only the $43,000.00 in her account.  This was essentially the result in Winstead.

If the actuarial net present value was used instead of the cash-out value to estimate the current worth of the KTRS Pension, the KTRS Pension would have been $20,000.00 in excess of the 401(k), and after a 50% division of the excess KTRS Pension, both parties would end up with $80,000.00; a result that is not only equitable, but clearly was the intent of Shown (i.e., the equalizing of retirement assets).   For this reason, it is this author’s opinion that in most cases, there is simply no other way to accurately and fairly compare a KTRS Pension with a private employer pension or a defined contribution type plan by virtue of 403.190(4), other than by reducing the pension assets to a net present actuarial value.  Apples to apples.

Personally I'm always ready to learn, although I do not always like being taught.
~ Winston Churchill

For those that read my blog posts, I always try to serve lemonade after picking the lemons, begging the question:  What does the family law practitioner do with a KTRS Pension in these circumstances?  The Court of Appeals tends to uphold and honor the trial courts’ broad discretionary powers.  A survey of case law reveals only that trial courts utilize either the cash-out value or actuarial value on a case-by-case basis, with little explanation, if any, as to why either method is ultimately chosen.  So without further clarity from the legislature or the higher courts, how can one predict any outcome at the trial court level? 

One solution may be to employ dual-QDROs to equally divide both spouse’s retirement assets; the dividing of retirement assets via deferred distribution does accomplish the level playing field envisioned by Shown.  When both parties’ retirement assets are divided by QDRO, the result is an equalizing of assets.  For instance, using the above example, if the 401(k) is divided equally via QDRO, providing for $35,000.00 to each spouse, and the KTRS Pension is divided equally via QDRO, providing for 50% of the retirement allowance or refund, whichever option is chosen by the KTRS participant, the spouses walk away on truly equal footing.  (The KTRS statutorily mandated QDRO form contemplates that the member may elect either a refund or retirement allowance, and thus allows the former spouse to be designated a share from both the refund and the retirement allowance, although her award would only be assigned from the whichever option the member actually chooses).

Moreover, the courts do not have to grapple with comparing retirement assets that are more akin to ‘apples to oranges’.  For instance, the KTRS Pension includes COLAs and participants do not pay into Social Security, the KTRS Pension also does not provide any survivorship annuity for the benefit of the former spouse in the event the participant were to die before retirement, or after.  This is very different from a private pension, which typically would not provide COLAs, participants do pay into Social Security, and survivorship annuities are required to be offered by the plan, in most cases, under ERISA.   The differences between a 401(k) type plan and a KTRS Pension are more obvious, and the difficulties of comparing the two are illuminated by the earlier example.

This is apparently how the Court got around the ‘apples to oranges’ problem presented in Fitzgerald v. Fitzgerald, No. 2012-CA-000532-MR (Ky. App. 2013) (see my blog post dated November 21, 2013).   In considering Husband’s request to buy-out Wife’s marital interest in his pension with Dow Corning through a lump-sum immediate offset (versus by QDRO), the trial court recognized that the spouses’ pensions would be difficult to accurately reduce to a comparable net present value in order to appropriately determine marital property rights.  The trial court observed that Wife’s KTRS Pension included COLAs and that she did not pay into Social Security, unlike Husband’s private employer pension (which did not include COLAs, and wherein he did pay into Social Security).  Thus, the trial court elected to utilize the deferred distribution method to equally divide both pensions via QDRO.  The Court of Appeals affirmed the trial court's methodology.

Although not the trial court's intention, the practical net effect was an equalizing of assets without the court having to first value both plans.  The same result that could have ultimately been achieved under KRS 403.109(4) and Shown (i.e., the equalization of martial retirement assets), but rather by the trial court first determining the net present actuarial value of the assets and then dividing the plan with the larger benefit via QDRO.  However, the dual-QDRO method employed by the Fitzgerald Court allowed it to skip entirely the step of first assigning a net present value to the plans, and thus, the Court was able to avoid speculation as to the pensions’ values in light of the many discrepancies between the two plans.  Seems like a perfect way to also get around the problem of deciding how to value a KTRS Plan against a non-KTRS retirement plan.

Fitzgerald’s clever use of dual-QDROs might be carefully tread in light of Eden, KRS 403.109(4), KRS 161.700, and 102 KAR 1:320, at least if such use is mandated by the court (see specifically KRS 161.700(6)).  In any case, until the law of the Commonwealth is made clear, and the proper valuation method for the KTRS Pension in divorce made certain, it seems to this author that the dual-QDRO approach would be an excellent compromise for the parties to explore during settlement negotiations in order to obviate the otherwise uncertainty and risk facing both parties at trial.  See McMullin v. McMullin, 338 S.W.3d 315, 322 (Ky. App. 2011) (observing well-settled law that parties may contract to any terms they choose for the division of marital property, so long as such terms are not unconscionable).

Author’s Closing Notes:

Practitioners should be aware that the Kentucky Retirement System (KRS) does not operate within the same statutory and regulatory parameters as KTRS with regard to QDROs.  This means the trial court may have much more latitude as compared to KTRS in terms of valuing and determining an equitable division of the parties’ martial property rights as to their mutual retirement assets.  Firstly, KRS is not subject to exemption (as KRS participants pay into Social Security), so the initial offset method of division is not so much at issue.  Also, be aware that KRS is not necessarily subject to a marital coverture fraction when assigning a percentage award to the former spouse, as with KTRS under 102 KAR 1:320; KRS specifically allows the use of a percentage without a fraction (see 105 KAR 1:190 (Section 10)). 

* See my blog post dated July 19, 2013 regarding the then-recent legislative updates to KTRS, specifically to 102 KAR 1:320, which directly affects QDRO submissions.