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This article was written by Michelle Smith and was published in the American Journal of Family Law in Fall 2007

The Rate Debate…
How (to choose), Where (to apply), When (to use) and WHY?
By Seth Kaplan, CFP, CDFA- Sacramento, CA and Michelle M. Smith, CFP, CDFA- New York, NY

As CDFA’s, divorce financial specialists, and collaborative/mediation practitioners, we are often solicited to determine and justify the ‘appropriate’ interest rate to use in divorce settlement negotiations. Common questions that we are asked include:

While we believe that it is important to keep it simple— especially in the spirit of compromising so that cases can be settled— it is also imperative to understand the nuances between the rate assumptions. Although it might be easy to use 5% as the default rate because it is ‘close enough’, the fact and circumstances of a case may dictate otherwise.

For example, when there are ‘underperforming assets’ (assets that generate less income than they are prudently capable of generating), the following scenarios commonly arise when a determination must be made about the amount of income that is available for support.

Scenario One:

The payor spouse may have legitimate reduced earned income but substantial non-income producing assets—i.e., elaborate primary residence, vacation homes, growth stocks, land, boats, cars, etc. He or she may argue that the only funds available for computing support are those that generate income. The obvious counter-argument is the payee spouse's claim that it is the payor spouse’s choice to have resources and assets which are non-income producing—therefore, income should be imputed to him or her based on what he or she could be earning.

Scenario Two:

Payee spouse allocates a large portion of his or her net worth to ‘underperforming assets’—i.e., by keeping the costly family residence, maintaining his or her liquid assets in low interest bearing savings account, etc. Payor argues that he or she should not be penalized because the spouse chooses to maintain the family residence even though he or she can not afford it or because he or she fails to allocate the assets in a way that will maximize income. Payor spouse believes that Payee spouse should be imputed income based on what they could be earning by using investments that have greater growth and income potential.

The above scenarios are common and underscore how investment income imputation can be a loaded issue with no standard consensus. As with spousal support and pension buy-outs, there is no single ‘right answer’ for determining the interest rate to be used. Rather, one needs to look to the particulars of the case to ‘match’ the best rate to a given scenario. A primer on different rates and methods follows.

This method involves using a fixed income security or index to determine the discount rate to be applied (i.e., Lehman Brothers Government - Intermediate Bond Index¹, the Merrill Lynch Municipal 3-7 Year Bond Index², or US Treasury Bonds). This approach could be selected because it is perceived to be low in risk (high quality bonds have low default risk).

If it is determined that this method is the best fit based on the set of circumstances, the next step would be to determine if it makes more sense to use a Trailing Average Return approach or a Current Yield approach.

For example, if you were negotiating a long-term spousal support buyout in the early 1980’s (when interest rates were in the high teens), it might have been ‘unreasonable’ to use a discount rate of 18% (which was the current rate in 1981). The same could be said during time periods when interest rates rates were at the opposite extreme, such as in the year 2001, when rates were near 2%. Although both interest rate environments differed greatly, they were both considered anomalies because they varied so much from the long-term averages. In these instances, the Trailing Average Return method would seem to be appropriate, because it is based on a multi-year average (as opposed to the current rate).

If on the other hand, you were negotiating a buyout for support that is short term in nature, the Current Yield approach may be warranted. Using the previous example, if you were negotiating a short term spousal support buyout in 2001 (when interest rates were very low), it might be justified to use the 2% rate considering the time frame involved, because there might not be enough time for the rate to return to the long term average.

Some potential limitations / considerations when using either of the Fixed Income Return Methods include:

• The Trailing Average Return Method might not account for the ‘real world’ interest rates that can be earned at the time of settlement. Are we in a ‘normal’ interest rate environment, historically, or in a period of extremely low or high rates? (which is why it might not be the ‘preferred’ method for short term scenarios)

• The Current Yield Method might be abnormally skewed (if the current interest rate environment is abnormally high or low), which could help one party or hurt the other

• If the income imputation is intended to address spousal and/or child support that would be subject to a COLA (as might occur for long-term support awards), this simple interest method may be an inadequate determinant relative to what would actually need to be earned

• Is it fair to use such a low rate when additional returns might be possible by taking a prudent balanced approach?

• The return of a fixed income investment is often dependent on the time factor (maturity) of the bonds that are held—i.e., using an index that is composed of bonds that mature in 30 years might not make sense if the duration of support is only 7 years.

The Commercial Annuity Method involves using the rates available through a commercial annuity to determine the discount rate to be applied.

As with the Fixed Income Return method, this approach is also deemed to be a relatively risk free way of providing an income stream. One of the ways that it differs however is the rates are actuarially adjusted to account for mortality, and the time value of money. Because the rates are regularly updated to account for current economic environment and life expectancy assumptions (and they can be ‘bought’ from insurance companies), it is considered to be an unbiased estimate of rates available in the ‘real world’.

An instance where the Commercial Annuity Method might be appropriate is in situations where a party has excessive non-income producing real estate assets. For example, take a situation where the payee spouse wants to keep the costly primary residence even though he or she can clearly not afford it. In this instance, it may make sense to impute income using the rate of return that is available through a reverse mortgage (which is a form of a commercial annuity), which could be a good indicator of the ‘real world’ value of that asset.

Some of the considerations that should be factored in when using this approach include:

• There can be differences when accounting for gender and mortality rates

• There can be differences in rates offered by different insurance companies

• As with the Fixed Income Methods, this approach might be inadequate if the income imputation is intended to account for COLA increases

This method involves using the trailing average returns of a diversified portfolio of investments (i.e., stocks, bonds and cash). For example, if the average annual return of a portfolio composed of 50% stocks and 50% bonds was 8.5%, this rate might be used.

The concept behind this method is that it is assumed to account for higher returns, using a ‘prudent’ approach to balancing risk and reward. It might be argued that this approach should be used, because in a ‘real world’ scenario, it is unfair to penalize one party because the other party does not want to take any risk with their investments. For example, if a risk free investment is only yielding 4%, but a balanced portfolio has historically returned twice that rate, one might argue that the differential should be assessed (based on what one could potentially earn).

Some of the considerations that should be factored in when using this approach include:

• Time Frame- If the time period involved is short term in nature, it may not be prudent to utilize an approach where short-term negative returns are commonplace and statistically probable.

• What was the historical investment style used by the parties while they were married? For example, if the parties historically invested in a balanced portfolio of different asset classes, this approach might be justified. If on the other hand, the historical allocation was mostly one of CD’s and government bonds, one might argue that this method should not be considered.

• Past performance is not a decisive indicator of future performance. Depending on where the markets are priced at the time of investment—if they are priced well above or below the historical trend lines—can greatly effect whether investments will outperform or under-perform the averages. For example, even though a balanced portfolio might average around 8.5% return per year over the long term (based on the historical trend), the results can be different if you start at a market peak (as it was in March of 2000) vs. starting when the market is undervalued (as it was in the early 1990’s).

The Withdrawal Rate Method uses historical market data to measure the ‘safe’ annual withdrawal rate that an individual can utilize from their investment assets in order to sustain the longevity of money over time. In other words, it addresses the question—how much money can one safely take from their investments each year, allowing for COLA increases, while maintaining a high probability that the assets will last their lifetime?

While this approach attempts to balance risk and reward, it accounts for the fact that investment returns are random in nature— one is never guaranteed a positive, linear return in any given year or time frame. This is true even with a conservatively balanced portfolio (i.e., 40% stocks, 50% bonds and 10% cash). Because it recognizes that funds will be withdrawn during down years as well (which can be magnified if the securities markets are down 2, 3 or 4 years in succession), the withdrawal rate used accounts for this to help ensure that the assets will not be depleted.

As with the Balanced Portfolio Average Return Method, this method involves using a diversified portfolio of investments (i.e., stocks, bonds and cash). It differs however in that the interest rate used are based on statistical withdrawal rate probability analysis using Monte Carlo simulations³ as opposed to assuming that an investment portfolio goes up a consistent percentage- a straight line- year after year.

Note: the withdrawal rate is different from an investment return. Studies have shown that in order for one’s assets to last for any 30 year period (in up and down markets), one can ‘safely’ use an inflation adjusted withdrawal rate between 4.1% and 5.6% per annum (depending on the asset mix and rebalancing rules used)?. This differs from an investment return, which assumes a linear year-to-year increases, which is unlikely in the securities markets.

Some of the considerations that should be factored in when using this approach include:

• Although this approach accounts for, and addresses, the risks associated with inflation (loss of purchasing power), it does not guarantee against market risk. By using a diversified portfolio asset allocation, market risk can be mitigated however.

• As with the Balanced Portfolio Return Method, the duration of time that is being considered might be applicable. If the time period for the buy-out or income imputation is short term in nature, this may not be the preferred approach being that loss of purchasing will not be of major consideration (as it would be for time periods of long duration).

• The studies have simulated different allocations between stocks, bonds and other asset classes. Depending on the aggressiveness of the mix, and the actual market environments that occur going forward, there can be differences in portfolio longevity. For example, at a 4% inflation adjusted withdrawal rate, a 100% bond portfolio only has a 77% probability of lasting 25 years, whereas a portfolio that is 75% stock and 25% bond has a 92% probability of lasting that time frame.

As outlined above, different interest rate methods may appropriate depending on the facts and circumstances involved. We will close with three examples:

Fact pattern:

7 year spousal support obligation
No COLA (Cost of Living Adjustment)
$10,000 per month obligation
Effective tax rate: 35%

What discount rate is used to determine the lump sum present value in lieu of the annual payments?

We would select the Fixed Income Current Yield Method for this case, resulting in a $481,186 lump-sum buy-out (using a 3.65% discount rate). Why?

Since it is a short term spousal support award, it makes sense to use an interest rate that is currently available (as opposed to a long term average). By taking $10,000 per month and reducing it by 35% (the effective tax rate), the monthly after-tax equivalent is $6,500. Since we are tax-impacting the monthly amount up-front, it makes sense to use a tax-free rate for bonds that have the same maturity duration as the award (which is an ‘apples-to-apples’ application). In our example, it would make sense for a New York or California resident to use a rate of 3.65%, which is the current rate for the respective state’s 5-year tax free bond index. By using this approach, there is consistency with the already tax-impacted monthly obligation.

Fact pattern:

Long term marriage (both parties are 45 years old)
20 year Spousal Support award until Payor spouse turns 65
Payee spouse does not work
Payee spouse is allocated the following property in the division of marital assets— $3,000,000 residence, the vacation home (worth $1,000,000) and $1,000,000 that is in an interest bearing savings account (earning 3% interest)

What ‘Method’ might make sense for determining the income imputation to the real estate assets?

We would select the Commercial Annuity (Reverse Mortgage) Method for the real estate assets. Why?

The ‘income payment’ available through a reverse mortgage is indicative of what can actually be ‘earned’ in the commercial market for the respective properties taking into account the specific time frame.

Fact Pattern:

Husband works for company for 20 years while Wife stays home raising the kids
Husband earned a pension from his company that will pay an inflation adjusted retirement benefit with annual COLA increases
Husband would like to keep his pension and is willing to buy-out wife
Wife would prefer to have cash on hand now which she plans on investing to provide a sustainable lifetime, inflation-adjusted income stream
The marital standard was to invest their liquid assets using a diversified portfolio of stocks and bonds

What interest rate method would we use determining the present value of the community interest in the pension?

We would select the Withdrawal Rate Method. Why?

Since wife will need to generate an inflation-adjusted income stream that will last her lifetime, the Withdrawal Rate method is the ‘safest’ rate to use because it factors in the need for purchasing power protection (unlike traditional fixed income securities—i.e., a Treasury bond— which does not adjust for inflation).

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