When a CalPERS member’s retirement status changes from a standard service retirement to an industrial disability retirement after a divorce is finalized, it raises a critical question: How does this change affect the court-ordered division of pension benefits?
The member’s monthly income often increases, and a significant portion may become tax-free. This understandably creates confusion about how the benefits awarded to the former spouse (the “non-member”) are impacted.
This post will break down the mechanics of a properly drafted Domestic Relations Order (DRO)—the court order used to divide a CalPERS pension—to explain how these complex situations are handled under California law and CalPERS rules. For a general overview of this process, you can read more about dividing CalPERS benefits in a divorce.
The Core Issue: The “Lesser Of” Clause Explained
At the heart of the matter is specific legal language within the DRO that dictates how the non-member’s share is calculated after the member’s retirement is reclassified. A typical DRO, including the one in our case file, contains a clause like this:
“If the Member retired on or is later approved for a service or non-service connected disability pension, then the Nonmember shall be entitled to the Nonmember’s System Interest equal to the lesser of: 1) Member’s actual disability retirement benefit, or 2) the benefit that would have been payable to Member as a service retirement allowance if Member’s termination of employment had not been for disability or industrial disability.”
At first glance, the term “lesser of” can be confusing. Why is it structured this way?
- Protecting the Non-Member: The primary reason for this language is to prevent a scenario where a member might intentionally select a disability option that pays less than their service retirement, purely to reduce the payment to their former spouse. While rare in CalPERS, this clause acts as a legal safeguard.
- Practical Reality: In practice, a member would not pursue a disability retirement unless it resulted in a higher monthly benefit. Therefore, the “lesser of” the two options will always be the original service retirement allowance.
- Separating Community vs. Separate Property: This clause enforces a critical California legal principle, established in cases like In re Marriage of Stenquist. The law holds that any increase in payment due to a disability is compensation for the member’s diminished future earning capacity and physical injury—not a retirement benefit earned during the marriage. As such, that increase is the member’s separate property and is not subject to division.
The DRO effectively locks the non-member’s benefit to the community’s interest in the service retirement, while ensuring the member exclusively receives the benefit of the disability enhancement.
A Deeper Dive into Tax Allocation
One of the most significant advantages of an industrial disability retirement is that a large portion of the benefit is often not subject to federal income tax. The DRO carefully addresses how this tax benefit is applied:
“Any tax-free benefits will be allocated first to Member and will be allocated to Nonmember only if Nonmember’s portion cannot be paid completely from taxable benefits.”
A common concern is whether the non-member’s share could ever be so large that it dips into the member’s tax-free portion. Under this DRO, the answer is no. Here’s why:
- The non-member’s share is calculated as a fraction of the service retirement allowance (using the “time rule” formula). This means the non-member’s share will, by mathematical definition, always be 50% or less of the total service retirement benefit.
- Because the non-member’s payment is a smaller piece of the larger taxable pie (the service retirement portion), it can never exceed that taxable amount. This ensures the entire tax benefit associated with the disability component flows exclusively to the member, as intended by law.
Once the DRO is processed by CalPERS, the pension is split into two direct payment streams. Each party becomes responsible for the taxes on their own distribution, which can sometimes be advantageous as two smaller incomes may be taxed at lower marginal rates than one large income.
The Irrevocable Choice: Retirement Options & Survivor Benefits
When a member retires, they must make an irrevocable election on how their benefits will be paid out. This choice has profound and permanent consequences, especially regarding survivor benefits. A DRO, processed after this election is made, cannot undo it; it can only enforce it.
The most common CalPERS retirement options include:
- Unmodified Allowance: The highest possible monthly benefit with no continuing survivor benefits.
- Option 1: A slightly reduced allowance. Upon the member’s death, a one-time lump-sum payment of any remaining member contributions is paid to a named beneficiary. If the member outlives their contributions, there is no death benefit.
- Options 2, 2W, 3, 3W, and 4: These are “survivor options.” They provide a continuing monthly lifetime allowance to a surviving beneficiary. To fund this future benefit, the member receives a significantly reduced monthly benefit during their lifetime.
In the case reviewed, the member had chosen Option 1 at retirement, naming the spouse as beneficiary before the divorce. The DRO makes this unchangeable, stating the non-member “shall remain the irrevocable beneficiary of such option and such election shall not be cancelled or modified”. This means the member cannot now name a new heir, such as a child, for that benefit. The choice made at retirement is locked in permanently.
This highlights why it’s so important to get these orders, often referred to as QDROs, DROs, or DBOs, completed as soon as possible during a divorce, before irrevocable elections are made.
Get Started With a Free Consultation
The division of public pensions involves layers of complexity. The interaction between California’s community property laws, CalPERS administrative rules, and specific court order language requires careful navigation to ensure a fair and legally compliant outcome.
If you are facing a divorce involving a CalPERS pension or have questions about how your benefits will be divided, it is crucial to seek expert guidance. Contact our firm for a free consultation to discuss your case.