Facts and analysis
The starting point for valuing pension benefits on divorce is the cash equivalent transfer value (CETV), calculated as if each party to the divorce were an early leaver from their respective pension arrangements. In Scotland, broadly speaking, the CETV should be based only on pension accrued during the marriage, whereas full accrual is relevant for the remainder of the UK. However, arguments often arise as to the appropriateness of the CETV as a means for valuing pension rights in such circumstances and this is considered later in this article.
There are three ways in which pension benefits can be dealt with as part of a divorce settlement; offsetting, earmarking or sharing.
This is the oldest and still most commonly used method of dealing with pension benefits.The value of the pension assets is taken into account in valuing the couple’s matrimonial assets, but the divorcing couple keep their own pension rights with the value of the pension rights being offset against other assets. The following highly simplified example explains how it works. The ‘husband’ has pension rights valued at £400,000. The marital home is worth £500,000 and the couple has other assets of £100,000. The divorce settlement may provide for the ‘husband’ to keep his pension rights while all or part of the other assets are passed to his ‘wife’.
Introduced by the Pensions Act 1995, and is effectively a form of deferred maintenance payment, i.e. where all or part of the pension benefits of one of the divorcing couple are ordered to be paid to the other spouse. Earmarking orders may also be made against a member’s tax-free cash benefits on retirement and in respect of lump sum death benefits. In Scotland, only lump sums can be earmarked. When a pension earmarking order applies, the pension paid to the ex-spouse will be taxed at the rate(s) appropriate to the member. As the ex-spouse’s earmarked benefits are treated as part of the member’s benefits they will be assessed against the member’s lifetime allowance.
- Pension sharing
This was introduced by the Welfare Reform and Pensions Act 1999 and the Finance Act 1999. In general a pension sharing order will be expressed as a percentage of the member’s cash equivalent transfer value under their pension scheme (in Scotland this can also be expressed as a lump sum). A ‘pension debit’ will be created in relation to the member’s rights and an equivalent ‘pension credit’ will be provided for the ex-spouse. The ‘pension credit’ benefits will be the ex-spouse’s own benefits, and depending upon the scheme providing the member’s benefits, may either be used to provide benefits for the ex-spouse under the member’s scheme or be transferred to a suitable registered scheme of the ex-spouse’s choice. However, where the member’s scheme is an unfunded statutory scheme (e.g. Civil Service scheme, etc.) the only option available to the ex-spouse will be for benefits to be provided under the member’s scheme in respect of the ‘pension credit’. Any ‘pension credit’ created on or after 6 April 2006 will count against the ex-spouse’s, rather than the member’s, Lifetime Allowance. However, where the ‘pension credit’ arises from benefits of the member that crystallised on or after 6 April 2006 (eg. a scheme pension, lifetime annuity or unsecured pension) the ex-spouse is able to elect for an enhanced Lifetime Allowance in respect of the ‘pension credit’. When a member’s scheme is an under-funded defined benefit scheme, the ex-spouse must be offered membership of the scheme, although a pension credit transfer would still be available as an option.
The following sets out some of the potential advantages and disadvantages of each of the three pension options:-
Offsetting may be attractive where:
- the divorcing couple are fairly young, both at work, there are no children involved and there are sufficient non-pension assets to allow offset
- the couple’s assets are such that even after the split they are still large enough to provide each party with sufficient resources to carry on with their lives
- the ex-spouse already has a decent retirement income, which would normally make pension sharing less appropriate.
Offsetting may be less attractive where:
- the member’s pension value is high compared to other assets which may make offsetting extremely difficult or impossible
- a replacement pension will be needed for the ex-spouse, which may be difficult to provide if the time to the ex-spouse’s retirement date is limited, money is short, or if the ex-spouse is not working
- life assurance benefits under the member’s pension scheme are lost by the ex-spouse
Earmarking suffers from a number of problems including:
- when considering benefits payable at retirement, the dependent ex-spouse can receive no benefit until the member decides, or is forced, to retire
- again considering the member’s benefits on retirement, the dependent ex-spouse will lose all benefits if she/he is predeceased by the member
- the pension benefits will cease if the ex-spouse remarries (unless the order is in respect of lump sum benefits)
- the member may effectively be able to reduce the benefits of the deferred maintenance payment. For example, the member could opt out of their employer’s scheme and make alternative provision by means of a separate savings vehicle (e.g. ISA) which would not benefit the ex-spouse
- the basis of benefits under the member’s scheme may change between the time that the court order is made and when the member retires
- the ex-spouse will need to keep the scheme trustees advised of any changes in his/her circumstances (eg. change of address, remarriage etc). This is particularly important as if it becomes impractical for the scheme to make payment to the ex spouse the scheme can make payment to the member instead.
Earmarking can, however, be attractive in a number of areas including:
- where the divorcing couple are in their 50’s and other forms of maintenance provision are inappropriate. This will particularly apply where the ex-spouse is unemployable (either because of their age or lack of experience)
- where the pension scheme does not have any readily realisable assets (e.g. where a small self administered scheme is almost wholly invested in the company’s own property, this will make sharing very difficult)
- where the lump sum death in service benefit is earmarked for the ex-spouse
- where the member is already in receipt of an annuity. Although it is possible to “share” an annuity, earmarking may be seen as more appropriate in many cases. For example, where an annuity is shared it will be achieved by creating a new pension or deferred pension with the existing provider. As any new annuity will need to take into account the state of health and relative ages of the annuitants at the time, it is quite possible that the pension available to the ex-spouse will be lower than expected. For instance, a wife divorcing a husband who is 5 years younger than her husband could not expect to receive half of his pension because of her greater life expectancy. Where an annuity is earmarked the need to set up a new annuity for the ex-spouse will be avoided as he/she will be receiving a maintenance payment of part of the member’s annuity. However, there remains the risk that the member will pre-decease the ex-spouse which will result in the earmarked benefits ceasing. In such cases some form of contingent life cover may be required.
Pension sharing seems most likely to be used in the following situations:
- where the ex-spouse is relatively close to retirement. The ex-spouse may find it very difficult to build up a comparable pension fund in the short remaining period to retirement
- where the divorcing couple are older. Here the ex-spouse will be able to take benefits from age 55 in respect of the “pension credit” rather than have to wait until the member retires (as would apply in respect of earmarking)
- where the ex-spouse may be thinking of remarrying. Unlike earmarking, any pension sharing arrangements would be unaffected by this.
Pension sharing may be less attractive where:
- the retention of the family home is a key priority for the ex-spouse. The sharing of the member’s pension rights may necessitate other assets to be shared (e.g. the family home). This could result in the sale of the “matrimonial home” and the need to trade down to a smaller property
- the ex-spouse already has adequate pension provision.