Understanding DivorceMate’s “Lump Sum” Calculations
Prepared by S. Christine Montgomery, B.A., LL.B., For DivorceMate Software Inc., April, 2015
DivorceMate’s Tools One software allows users to determine appropriate life insurance
amounts, calculate lump sum spousal support payments and restructure periodic payments of
spousal support. Each of these calculations incorporates a “net present value (NPV)”
calculation, often referred to as a “lump sum” calculation.
What actually goes into this lump sum calculation and what do users need to understand about
this calculation?
In a nutshell, the NPV or lump sum calculation is a determination of the lump sum
value of the net cost/benefit of fixed periodic support payments to the party over a
specified period of time, discounted to reflect today’s dollar values.
It is helpful to break down this statement into its various components to better understand the
calculation.
“lump sum value”
When determining the lump sum value of a periodic spousal support payment, the software
takes into consideration the fact that spousal support paid as a lump sum payment is non-tax
deductible to the Payor and non-taxable to the Recipient (unlike periodic spousal support).1 It
does this by taking into account the parties’ respective tax positions (see next section).
“net cost/benefit of fixed periodic support payments to the party”
The software looks at the tax consequences of the periodic spousal support payment to each of
the parties. In other words, the software considers the after tax cost of the periodic payment
of spousal support to the Payor and the after tax benefit of the periodic payment of spousal
support to the Recipient.2 It is this after tax cost/benefit that then gets present day valued.
If the parties are in different tax brackets (ie. have different marginal tax rates), then the after
tax cost to the Payor will necessarily be different than the after tax benefit to the Recipient.
Accordingly, the software generates two different lump sum values – one for the Payor and one
for the Recipient.
1
Since periodic child support is non-tax deductible to the Payor and non-taxable to the Recipient anyhow, this
point is not relevant when calculating the lump sum value of child support for life insurance purposes.
2
The software considers only the tax implications of paying/receiving spousal support; it does not take into
consideration the effect of spousal support on benefits and credits in determining the net cost/benefit of support.
In addition to providing the lump sum value for each party based on his/her tax position, the
software also provides the mid point between the party’s two lump sum values. This mid point
is provided simply as a reference. When trying to settle a case or determine the appropriate
lump sum figure, there is no single magic answer; ultimately it is up to the
parties/court/mediator to determine the figure (most likely somewhere in between the two
values) that is most appropriate in the circumstances and with which both parties can live.
Also, it is important to remember that the periodic support payment and the taxation rates
applied necessarily remain fixed/constant throughout the duration of the calculation.
“over a specified period of time”
In determining the lump sum value, the software also looks at the length of time that the
periodic payment is to be paid.
For spousal support, the default duration is the mid point of the SSAG duration. This default
duration, however, can easily be changed by the user by clicking on the spousal support
duration in blue in the “Net Present Value (NPV) Assumptions” under the Support Scenarios,
and specifying a different duration. If desired, the duration can be specified as the Recipient’s
life expectancy, in which case the software will apply actuarial mortality tables to determine the
probability that the Recipient will still be alive to receive the payments for each successive year.
For child support, the default duration is until the child turns the age of majority (either 18 or
19 depending on the province). This duration can also be changed by clicking on the child
support duration in blue and specifying a different age. Since the lump sum calculation of child
support only takes into consideration the Table Amount of child support (and not special
expenses), it may be appropriate to lengthen the duration a few years to compensate
somewhat for this limitation.
“discounted to reflect today’s dollar values”
This is the most problematic or least understood component of the calculation. Essentially
what the software does is look at the stream of income/support set out in the calculation and
determine how much money a party would need to have and invest today to generate this
stream of income for the future. It does this by “present day valuing” this stream of income,
which means that it takes the specified (net) support amount over the entire duration and
applies a discount rate to take into account the fact that the money will be invested today and
earn interest over time.
The question then becomes what is the appropriate discount rate to apply?
There are two specified discount rates in the software, as well as a third option to specify a rate
of the user’s own choosing. The two specified rates are based on bond rates set by the
Government of Canada. As such, they are well recognized and conservative risk free rates.
Option 1 - Indexed (ie. discounted for inflation)
This “indexed” discount rate is based on the risk free rate of return currently available from a
Long-Term Government of Canada Real Return Bond. It is the default rate in the software as it
is truly the most risk free rate of return, provided that the periodic payments of support are to
be indexed according to CPI in any court order/agreement.3
A Real Return Bond is a bond that is completely protected against inflation. While these types
of bonds have a lower coupon interest rate than traditional bonds, their principal gets adjusted
twice a year according to the actual rate of inflation in the CPI. Accordingly, interest earned is
guaranteed to be over and above inflation since it gets paid on the principal value as adjusted
for actual inflation. At maturity, it is the bond’s principal value as adjusted for actual inflation
that gets repaid.
The discount rate used in the calculation is the effective yield to maturity of the Real Return
Bond, which reflects current market conditions, inflation expectations etc. As noted above, the
yield derived from a real return bond is lower than a regular bond because it guarantees that
the principal and interest components are indexed according to changes in the CPI. Therefore,
in applying this discount rate in the calculation, the support payments are effectively indexed
for currently anticipated inflation in the CPI over the next 20-30 years (ie. this discount rate
implies that the periodic payments of support will be similarly indexed according to CPI).
It is important to appreciate that unlike the value of a Real Return Bond which reflects changes
in the CPI over time, the rate applied in the calculation is necessarily static and is based on the
anticipated inflation in the CPI over the next 20-30 years, at the time of the calculation. The rate
applied in the calculation is determined quarterly, and is based on the average rate over the
prior 3 month period.
Option 2 - Not Indexed (ie. NOT discounted for inflation)
This “not indexed” discount rate is based on the risk free rate of return currently available from
a Long-Term Government of Canada Benchmark Bond. Unlike the Real Return Bond rate above,
this rate does not index support payments over the projected duration, and is the appropriate
rate to apply if support in the court order/agreement does not provide for indexing according
to CPI.
The rate applied in the calculation is determined quarterly, and is based on the average rate
over the prior 3 month period.
3
If the support is not indexed according to CPI in the court order/agreement, then the “Not Indexed” discount rate
should be applied.
Option 3 - Specified
Alternatively, the software provides the flexibility for the user to specify the appropriate
percentage discount rate to be applied in the lump sum calculation. Be aware that this can
have a dramatic impact on net present values and should be used with extreme caution.
Since it is a departure from the above-noted risk free rates of return, it will be noted with a
caution symbol in the “Cautions/Overrides” section of the Printout.
Contingency Discount
The lump sum figure calculated by the software does not apply a contingency discount. If the
circumstances warrant such a discount, the user simply needs to reduce the lump sum value by
the appropriate contingency rate.