The Disability Issue in the Distribution of Military Retirement Benefits

Here’s a look into how the courts and the legislature view the distribution of military retirement benefits. An essential resource for family lawyers.  

By Mark K. Altschuler, Actuary and Pension Valuator

In McCarty v. McCarty,[i] the US Supreme Court held that military retired pay was not to be treated by state courts as community property in divorce cases. In response, Congress passed the Uniformed Services Former Spouses Protection Act (USFSPA), which allowed military retired pay to be treated as property that can be distributed in divorce cases by state courts. In Mansell v. Mansell,[ii] California court had divided the husband’s military disability payments but the US Supreme Court reversed, holding that USFSPA did not authorize treatment as divisible property of divorce military retirement pay which had been waived so as to receive veteran’s disability benefits.

Military retired pay can be divided under a Military Court Order (MCO), which is the military’s version of a QDRO. The MCO is processed by the Defense Finance and Accounting Service (DFAS). The former spouse can receive no more than 50 percent of the member’s disposal retired pay under an MCO.

Distribution of Military Retirement Benefits: The Case of Disposable Pay

The law allows only disposable military retired pay to be divided. Disposable pay is defined as “military retired pay after the following deductions”:

• Debts owed the US government
• Amount of retired pay waived for receipt of disability compensation from the Veterans Affairs Department
• National Service Life Insurance premiums
• Survivor benefit premiums for a former spouse receiving payments under USFSPA

A veteran may receive anywhere from 10 percent to 100 percent of his or her retired pay in the form of disability pay. Although the injury must have occurred in the line of duty, the disability waiver can come later, and, in some cases, after the divorce, reducing the amount of property available for equitable distribution.

Veterans have a dual incentive for receiving as much retired pay in the form of disability as possible. Not only is it non-divisible in the case of divorce, but VA disability compensation is not counted as taxable income by the federal government. When the disability waiver comes after divorce, reducing the share available to the former spouse, it can have an unfair effect on the former spouse. The purpose of this article is to propose various remedies regarding the disability issue. The remedies deal with disability election after the divorce.

If there is a pre-existing disability before the divorce or cut-off date, the remedy is only applied to a disability election occurring after the marriage.

Distribution of Military Retirement Benefits: Sum Certain

The most obvious, practical method is the use of a sum certain contract between the parties. If the award to the nonemployee former spouse is an MCO in the form of a percentage of the participant’s “disposal retired pay,” the amount payable to the former spouse will be reduced if the participant takes all or a part of his or her retired pay as disability. Therefore, a contract between the parties, outside of the MCO, is needed to protect the former spouse. For example, suppose the participant accrued a retirement benefit as of the cutoff date of $1,500 per month, in the Reserves. Assume that the participant is age 55. The retirement age in the Reserves is age 60. With no future service, the participant’s benefit will still increase between the current date and retirement, due to pre-retirement cost of living increases. Therefore, the benefit in the contract should include an estimate of the pre-retirement cost of living increase. A conservative estimate is 2 percent per year, because the increase over the last few years, a period of low inflation, has been greater than 4 percent per year. The highest-ranking officers have the lowest rate of increase, and the rate of increase for these officers has been slightly greater than 4 percent per year over the last few years. Then, the estimated marital benefit at retirement is $1,500 x (1.02)⁵ which is $1,656. Assuming the former spouse’s portion is half of the marital portion, the sum certain guarantee to the former spouse is then $1,656 divided by 2, or $828 per month. This amount would be guaranteed in a contract between the parties, outside of the MCO.

Counsel for the member may object to the pre-retirement Cost of Living Adjustment (COLA) calculation. Therefore, all sides need to understand how the benefit is calculated in the Armed Forces Retirement System. If the member is active, the formula uses final basic pay, or high 3 average basic pay, depending on the date of entry. Even with no promotion, basic pay increases every year. For the last few years, the rate of increase has been at least 4 percent per year. The lower the rank, the higher the rate of increase. Thus, assuming a rate of increase of 2 percent per year is conservative, and does not assume promotion.

Armed Forces personnel on active duty may retire at 20 years of service, but may continue to serve. Suppose the member has 16 years of service. Then, the pre-retirement cost of living factor would be (1.02)⁴ or 1.0824. Because the member may continue to serve, this is a conservative factor.

The Armed Forces Retirement System has a 20 year “cliff” vesting schedule. If the member leaves before attaining 20 years of service, he or she forfeits the right to an active duty retirement. In most cases, the member then joins the Reserves, and is still entitled to a military pension, at age 60. All the active duty service is counted toward the Reserve retirement. In computing a Reserve member’s retirement benefit, the Reserve “points” history is used. Points are used to account for the part time nature of the Reserves.

At retirement, the total of the Reserve retirement points over the member’s entire career is multiplied by the point value coefficient. For the years of active duty, the number of points accrued are 360 per year. Typical Reserve duty annual point totals are about 75 per year. The point value coefficients are tied into the basic pay, and also increase every year, due to the basic pay increase. The high ranking officer’s increase has been 5 percent per year, the same as the basic pay increase. Thus, the same method of calculating the pre-retirement COLA applies to Reserves.

The sum certain method does not normally take post-retirement COLA into account. To do that, there would have to be a table showing what the sum certain amount is for every age after the normal retirement age, until some age well beyond the member’s life expectancy. This can be done, but adds a level of complexity to the contract. For example, assume that the former spouse’s guaranteed amount is $828 per month at the member’s age 60, and the 2 percent conservative COLA is now applied to post-retirement; this would result in $845 the next year, and $861 the year after that. The full table is as shown on your right.

Another issue regarding the sum certain approach is current disability. If the Armed Forces member has a pre-existing disability rating at the time of the divorce, then this amount should be excluded from the sum certain calculation. This is not the disability itself, because, technically, the disability must have occurred during the military duty. The important classification is the Veterans’ Administration disability rating. Suppose, at the time of divorce, the rating is 15 percent. The marital portion of the benefit, at retirement, estimated with the conservative 2 percent preretirement COLA factor, is $1,656 per month. But the non-disability portion is 85 percent of this, or $1,408 per month. Therefore, 50 percent of the non-disability portion of the marital component is $704, which is the amount to be used in the sum certain contract. Counsel for the member will want to ensure that preexisting disability is thus accounted for.

Because it is possible that an active duty member of the Armed Forces could possibly leave before 20 years and also not vest with the Reserves, the language in the contract between the parties should account for this. Obviously, if the member receives no military pension, the sum certain contract would not apply. A member leaving active duty before vesting may be entitled to separation pay. While the sum certain contract would be null if the member does not vest, there should be language regarding the separation pay. However, several states have found that the separation pay is not marital property.[iii]

State courts will almost certainly uphold a sum certain contract between the parties .[iv] When the member’s disability pay increases and disposal retired pay decreases, the member might argue that the spouse’s award should cease. But, this argument is illogical, because the whole point of the sum certain contract between the parties is that disability would have no effect on the spouse’s award. Not only did the court find against the member in one such case, but the member was penalized for bringing a frivolous suit[v].

A Fixed Dollar Amount

Rather than a sum certain contract outside the MCO, why not have the MCO based on a fixed dollar amount, instead of a formula? The reason is that this still does not protect the former spouse. Recall that the former spouse may receive no more than 50 percent of the disposal retired pay under the MCO. In the model above, the former spouse is supposed to receive $828 per month. Suppose the member receives a total pension of $2,000 per month, with a 50 percent disability rating that occurs after the marriage. Then, the disposable retired pay is only $1,000 per month, and the former spouse’s award is capped at $500 per month. The former spouse may receive more than 50 percent of the disposable retired pay if the additional percentage is considered alimony or child support, not property division. But, this would entail an alimony clause within the MCO to be triggered by the fixed dollar award. However, even with alimony, the maximum amount of disposable retired pay that can be awarded to the former spouse is 65 percent. Thus, with the 50 percent disability rating, the most the alternate spouse could receive is $650, while the award is supposed to be $828 per month.

The former spouse receives payments directly from DFAS under the MCO, and he or she will also pay taxes on these payments.

Distribution of Military Retirement Benefits and Indemnity

While the contract, decree or property settlement agreement should ideally contain a sum certain clause, indemnity language will have the same effect. The property settlement agreement should contain a clause stating that the member will take no action that will reduce the former spouse’s share and will indemnify the former spouse for any reduction. Note that this language will automatically cover the situation of preexisting disability, because it deals with future action only. Also, the use of indemnity language, as opposed to a certain contract, has the advantage of covering the post-retirement cost of living situation automatically.

If the member receives a higher disability rating after retirement, any drop suffered by the former spouse will be apparent, and the member will have to make up the difference, under the indemnity clause. But suppose the member raises his. or her disability rating after the marriage, but before the retirement. Unless the calculations that are performed for the sum certain contract are done in the indemnity method also, the former spouse would not know how much harm was caused by the increased disability rating. This is the disadvantage of using an indemnity clause without specific sum certain language, or at least without support calculations.

If the member defaults on an indemnity clause, the courts will almost certainly enforce the indemnity language.[vi]

Even if there is no express indemnity clause in the property settlement agreement, the court may find that indemnification was implicit. In other words, there was no intent for one of the parties to reduce the other’s benefit by electing disability benefits. For example, in Hisgen v. Hisgen,[vii] where the property settlement agreement stated that the husband waived retirement benefits to receive his pension in the form of disability, the court held that the husband had a duty to indemnify the wife for her loss.[viii]

Res Judicata

The weakest method of protecting the former spouse’s portion is res judicata, but it can be effective. For example, consider Mansell v. Mansell case itself. The sequence of events was as follows:

• The husband appealed the order dividing his disability benefit.
• The California state court initially assumed judgment could be reopened.
• The California state court denied relief, finding that disability could be divided.
• The US Supreme Court reversed the California court (disability held non-divisible).
• The US Supreme Court did not rule on res judicata. Whether or not case could be reopened “is a matter of state law for which we have no jurisdiction.”
• The California state court revisited the earlier assumption that res judicata did not apply and refused to reopen the judgment. It found that “while the judgment might be erroneous, it was not void.”
• The husband appealed to US Supreme Court, which refused to hear the case a second time.

Because of the precedent set in Mansell, “decisions which violate Mansell are only erroneous; they are not wrong.” Thus, a state court has the jurisdiction to divide disability benefits, even though such a judgment is erroneous.[ix]

Taxes

If the member indemnifies the former spouse either by a sum certain agreement or an indemnification agreement, the result is that the member must make up any shortfall due to disability. Suppose the payments to the former spouse decrease by $100 per month due to disability election, and under the agreement the member must make up the $100. If the former spouse received the $100 from DFAS, he or she pays taxes on her share, and would only receive $80, assuming he or she is in a net 20 percent tax bracket (also ignoring state and local taxes, for simplicity). However, if payment comes directly from the member, counsel for the former spouse may argue that this transfer of property fell under Internal Revenue Code Section 1041, and was therefore not subject to taxes. In this situation, the payment directly from the member is worth more to the former spouse than payments from DFAS. But where does the $100 come from? If it comes from the member’s other income or the non-disability part of the member’s pension, the member is then paying taxes on this amount. Assume that the money is coming from the non-disability part of the military pension. If the member is in the 20 percent bracket, he or she must take $125 from this pension to give the former spouse $100. Thus, if the $100 is paid directly to the former spouse by DFAS, he or she receives $80 after taxes, and $100 is taken out of the member’s pension. But, if payments go from the member directly to the former spouse, he or she will receive $100, and $125 must be taken out of the member’s pension. This may see unfair, and counsel for the member may want the sum certain agreement to take this into account. However, counsel for the former spouse may then point out that if the member had not chosen the disability, this penalty would not have occurred. In addition, the member does not pay tax on the disability part of his or her pension. Therefore, the member will at least come out even.

Suppose the member is receiving $2,000 per month, with a 50 percent disability rating. The former spouse’s share is $828 per month. This must come out of the $1,000 left that is disposable. But the former spouse’s share is capped at 50 percent of the disposable retired pay, which is $500 (assuming there is no alimony clause). The member must make up the difference of $328 per month. The member must take $410 out of the remaining $500 of disposable pay if the member is in the 20 percent bracket, in order to have $328 for the former spouse.

Therefore, there is a tax penalty to the member of $82 per month, in the sense that the member is paying $82 in taxes on money that is not his or hers. But, by receiving half of his or her pension in the form of disability, the member is not paying taxes on $1,000 per month. Assuming the 20 percent tax bracket, this is a tax savings of $200 per month. Thus, the member has a net tax savings of $200 $82, or $118 per month. As a result, the most equitable solution is for the former spouse to receive the sum certain payments as property under Internal Revenue Code Section 1041, because both sides come out ahead in terms of taxes.

Conclusion

Given the current status of the law, there are several remedies that can be used to protect a former spouse from reduction in his or her share of the marital portion due to the member receiving disability:

• A sum certain contract attached to the property settlement agreement offers the most protection.
• An indemnification clause in the property settlement agreement, which has some advantages over the sum certain agreement concerning the issues of pre-existing disability, termination without vesting and post-retirement cost of living increase.
• Implicit indemnification within the property settlement agreement; but, this is no guarantee.
• A res judicata argument that a court order awarding a former spouse a percentage of disability benefits may be erroneous, but not automatically void.

Remembering that Congress passed the USFSPA because of the unfairness of the McCarty decision (under which the military pension was not divisible), it is possible that Congress may find a remedy to the Mansell decision.

Mark K. Altschuler, Actuary, is President of Pension Analysis Consultants, Inc., (PAC) of Elkins Park, PA. He has performed over 25,000 pension valuations and QDROs .  He has spoken about this and other topics at state and local bar associations and CLE workshops. An affiliated member of the American Society of Pension Actuaries and Professionals (ASPPA), Mr. Altschuler writes a nationally distributed newsletter on pension issues in divorce (DIVTIPS®) and is a contributing author to the books, Valuing Specific Assets in Divorce and  Valuation Strategies in Divorce: Aspen Publishers/Wolters Kluwer, New York.