Government Pensions & Social Security - A Valuation Approach For Property Offset

The complexity of the Social Security system has made it difficult for individuals, attorneys, and the courts to properly offset government pension plans involving participants who do not contribute to Social Security. The problem lies in the fact that Social Security is not a divisible asset under the law, thus it is not counted as a retirement asset in divorce situations. However, the entire pension plans of government employees who do not contribute to Social Security, but rather contribute a greater percentage of their income toward their retirement benefits than those in the private sector in lieu of Social Security, are subject to division or property offset. The government employee spouse is in effect penalized for their participation in a government pension plan.

Most traditional "non-governmental" defined benefit pension plans are one hundred percent employer funded. The spouse who participates in such a plan also contributes to, and will receive, Social Security. Conversely, the participant in a governmental plan may contribute upwards of six to eight percent of their earnings to their government pension plan, and will not receive Social Security. The governmental employee pension plan, such as the Civil Service Retirement System, compensates for the reduction in Social Security by providing participants a higher than normal retirement benefit. However, in divorce situations, governmental employees may find their entire government pension subject to division or property offset against other assets of the marriage.

A governmental employee's contribution to a pension plan simulates precisely the Social Security contributions made by individuals working in the private sector. After 1984, participants in the Civil Service Retirement System (CSRS) for example, had the option of joining the then-new Federal Employees Retirement System (FERS). FERS participants, however, contribute only 1% (.01) of their earnings toward their retirement rather than 7.2% under CSRS, yet FERS participants are eligible to receive Social Security benefits at retirement based upon their FERS covered employment. Although this article uses the Federal Government retirement scheme for illustrations, the same concepts or interpretations can be applied to other government pension plans, including municipal retirement plans where protective employee pension participants may not contribute to Social Security, i.e. firefighters or police officers.

‍Note that the difference in contribution rates parallel the rate individuals pay into Social Security in FERS and private sector employment.

Example: In the case where both parties to a divorce are employed, with each individual having a separate earnings history, and assuming one is a government employee not contributing to Social Security, it would be unreasonable to assume that the lump-sum present values of each party's pension plan are comparable, since the governmental employee has not contributed to Social Security and will not receive Social Security benefits. For illustrative purposes, all other factors remaining equal, if a governmental employee received a pension benefit of $1,700 per month while the non-governmental spouse collected a private pension of $1,000 per month with an additional $700 in monthly Social Security benefits, it would seem inequitable to divide only the non-governmental spouse's private pension while subjecting the entire governmental pension to division/property offset. Therefore, an allowance should be made for the spouse not receiving Social Security benefits.

However, because the Social Security Administration does not get involved with marital dissolution matters or the valuation of pensions as assets, the Social Security Administration will not expand on or address these issues. The Social Security Administration, along with the Office of Personnel Management in Washington, does recognize that a portion of governmental pension plan represents benefits "in lieu" of Social Security. However, they are not in a position to determine the value. The idea of the government pension being enhanced is evident by certain offsets which the Social Security Administration applies to the Social Security benefits, if any, that the government employee may have accrued outside of participation under this type of plan. Again, the offset(s) and the valuation approach only applies to those pension participants who did not contribute to Social Security.

The problem of deducting the "Social Security" element out of the plan is two-fold. First, in order to determine this element, a complete earnings history would have to be compiled, specifically with regard to the years during which the participant in the government plan was employed. Second, if the non-participant spouse has never been employed, and the portion attributed to Social Security under the plan is excluded, the non-participant spouse may not be eligible to collect Social Security from earned wages of their former spouse at any time. The non-participant would need to accrue their own Social Security earnings history. The Social Security deduction concept most fairly applies to an individual such as a police officer or firefighter, who has been employed by a state or local government for several years and can retire with full benefits at a much earlier age than the average person. Present values for protective employees (those employees not contributing to Social Security) can be in the hundreds of thousands of dollars, with longer payout periods and cost-of-living adjustments contributing to much of the value. Deducting what would have been applied to Social Security not only makes sense, but offers a more equitable solution when dealing with this issue. In addition, the deduction would not apply in a case where the non-participant spouse has no earnings history, as neither party will collect Social Security and the pension may be the only source of retirement income.

The attorney calculating the Social Security deductions would first need to understand the present value process and be able to incorporate the cost-of-living adjustment, if needed, before determining the Social Security element. The first step is to calculate the overall present value of the monthly benefit using a present value formula, or spreadsheet, which incorporates annual increases. A mortality discount should be applied for the probability of death prior to attaining the retirement age used, and further, a present value of that lump-sum at retirement should be computed to bring that value back from the retirement age to the date of valuation.

Keep in mind that most plans of this nature indicate an account balance as well as a monthly benefit amount. The account balance given should not be mistaken for the present value. Typically. the account balance given by the plan represents the employee contributions only, is often unrelated to the monthly benefit, and represents only a fraction of the actual value of the plan. This account balance would not include employer contributions nor take into account cost-of-living adjustments or post retirement increases. The account balance is often referred to as a separation benefit and considered a severe penalty when compared to the value of the deferred monthly benefit. Statistically, very few terminating participants ever elect such a separation benefit or "refund of contributions" and opt instead to keep their contributions in the system.

Once the attorney has obtained the appropriate income figures for the period of the participant's employment with the government, this information can be entered into a Social Security benefit calculation program offered for sale by the U.S. Government. Though comprehending arcane Social Security terminology and wrestling with the idiosyncrasies of the software program may require painstaking hours in muddling through the first few cases, it is time well spent. After computing a monthly Social Security benefit at age 65, or a reduced benefit at age 62, a present value of the calculated Social Security benefit is determined and then subtracted from the overall present value of the plan. This resulting value then would be comparable in terms of methodology to the lump-sum present value of the participant's actual pension benefits without Social Security. This process is, in effect, computing the Social Security element by assuming a portion of the participant's earnings were applied to Social Security.

Calculation of the Social Security element does not end with a present value calculation and deduction. The Social Security Administration does apply certain offsets, particularly the Government Pension Offset Rule, and the Windfall Profit Elimination Rule.

First, however, the attorney may want to advise their client, regardless of the client's pension benefits, that they may be entitled to Social Security benefits larger than the Social Security benefits they accrued individually through what is referred to as the Divorce Spouse's Annuity. The Divorced Spouse's Annuity entitles a spouse who earned less than their former spouse to collect an additional benefit derived from the former spouse who has the higher Social Security benefit, pursuant to Social Security Administration regulations. Therefore, the spouse with the lesser earnings would receive the greater of their own Social Security benefit or a percentage of their spouse's benefit, but not both. Under the Divorced Spouse's Benefit, the spouse applying for the benefit cannot be currently married if they are to collect the annuity payment. Oddly enough, the spouse applying for the Divorced Spouse's Benefit could be twice married and divorced, as long as they are not married at the time they apply for the Divorced Spouse's Benefit. They may be eligible to collect either their own Social Security benefit, the benefit based on the earnings of their first spouse or the benefit based on the earnings of their second spouse, whichever is greater.

The Government Pension Offset Rule applies to government employees not contributing to Social Security who's spouse will receive Social Security. As in many cases, one spouse may apply for Social Security based on the other spouse's Social Security benefits. However, the Government Pension Offset Rule severely limits, if not makes it impossible, for a government employee to receive any portion of their spouse's Social Security or widow's benefit.

The Windfall Profit Elimination Rule, which is a penalty, applies to an individual who not only accrued a government pension benefit, but who also accrued Social Security benefits through employment outside of his/her employment with a federal, state, or local government. The amount accrued in the government pension can reduce the Social Security benefits accrued by as much as 55%.

The practitioner faced with calculations of the Social Security offset faces a formidable task. Proper calculation and analysis of the Social Security offset requires a thorough analysis of present value formulations, as well as evaluation and application of the Social Security Administration's guidelines. As a practice tool, and when confounded by the Social Security issues, the practitioner is urged to contact the Social Security Administration at 1-800-772-1213 to evaluate all issues and calculations.

We all know that each case is different and presents its own unique set of facts. Subtracting the Social Security element may not apply to all situations or circumstances. For instance, subtracting the Social Security element may not be applicable in cases where one spouse has accrued Social Security benefits and the other spouse has not, or if a government-employed spouse has accrued a substantial amount of Social Security benefits outside of government employment. The appropriateness of determining the Social Security element of a retirement benefit should be considered on a case by case basis.

Tim Voit is author of "Retirement Benefits & QDROs in Divorce, a CCH Publicatyion, and is a Financial Analyst with WFA Econometrics Group, L.L.C.