Divorce and Pensions
Important Note: While this article gives a brief outline of the options available with dividing pension assets upon divorce, getting appropriate legal and financial advice is an absolute necessity if you are considering (or are going through) the process of divorce.
At this point we are not going into any detail about what 'divorce' is, and the legal steps necessary to obtain one, as there is sufficient information available elsewhere on the web about this topic. If you read any further, it will make the assumption that you have some understanding about the divorce process in England and Wales, and you are mainly concerned with issues surrounding 'ancillary relief'.
When a marriage has irretrievably broken down, and the divorce process has been put into motion, the financial settlement side of the divorce is usually seen as one of the most important aspects of the divorce. If the parties to the divorce do not have any childcare responsibilities, then it is seen as THE most important aspect to be settled.
When it comes to negotiating the settlement, pension rights should be taken into account - however, until relatively recently, pension rights were often neglected or under-valued when constructing the overall settlement.
For many individuals aged 40 or over, their pension rights or accumulated pension funds can easily be one of their largest assets. Sometimes it can be of greater value than their property.
Therefore, the sharing of pension rights on divorce has become an important topic. However, unlike properties and other tangible assets that are relatively easy to value, valuing and sharing pension rights can be slightly more complicated, as will be outlined shortly.
The background
Legislation that deals with pensions upon divorce has been evolving since the 1970s - however until 1996, benefits could only be provided by the sharing of other matrimonial assets such as the family home, to compensate for the loss of pension rights by the other spouse. This is known as offsetting.
The method of attachment (also known as 'ear-marking'), was introduced in the Pension Act 1995, and became effective for divorce petitions from 1 July 1996.
However, the most recent, and arguably the most important piece of legislation is the Welfare Reform and Pensions Act 1999 that allowed 'Pension Sharing' for the first time - this allows for a true division of pension benefits.
However, before we go into this in greater detail, we need to backtrack a little and look at the actual process.
Upon application to the court for a divorce, the first concern of the Family Court will be to make suitable arrangements for the children of the divorcing couple (if there are children involved). Only when this is resolved do they move on to the process of 'ancillary relief', which concerns the division of the matrimonial assets. Often this can be the most time consuming part of the process, unless both parties to the divorce are already in agreement about how assets will be split.
As mentioned previously, assets such as properties, cash, automobiles, etc, are easy to value, and therefore easy split or offset. However, when it comes to pension rights, there are a number of solutions that can be used. These include:
- Offsetting
- Maintenance
- Earmarking
- Pension Sharing
- Offsetting
Effectively this boils down to little more than one party retaining 'Asset A', while the other party retains 'Asset B' that is equal value.
As a very basic example, a couple own a property worth £250,000, and the husband has a Pension Fund worth £250,000. In this case, the wife receives the property, and the husband retains the pension fund.
Realistically, there would be other factors involved - especially if on-going maintenance is being paid, and the property needs to be sold and the proceeds distributed in order to allow each party to purchase separate properties. In such a case, the offsetting principle could still be used, with the wife taking a larger share of the proceeds, and the husband retaining the pension fund. Such 'splits' are often not worked out on an equal 50/50 share, and can favour one party more than the other, depending on numerous factors.
Whilst offsetting has been used a great deal in the past, it can have the effect of leaving one party (usually the ex-wife) 'pension poor'.
Maintenance
While maintenance payments are primarily used to provide financial support to a divorcing party who is not in the position to become financially independent in their own right, they can also be used to provide additional pension payments (whether directly or indirectly).
In many divorce cases, the value of the pensions may be insufficient to split, or there may be insufficient capital to offset the value of the pension funds.
Therefore, this can often pose something of a dilemma. Maintenance payments usually continue for a fixed amount of time, and usually cease upon either the remarriage of the person receiving them, or upon the death of person providing the maintenance.
While additional maintenance can be used to supplement income directly, it can be argued that because private pensions are effectively 'deferred pay', some arrangements could be made to provide third-party contributions to the party who is pension-poor.
As an example, where there are insufficient assets to offset or split, and the ex-wife has no private pension provision of her own (and no immediate ability to build up any pension funds), it could be negotiated that the ex-husband makes contributions to a personal pension plan for the benefit of the ex-wife. The benefits under the plan will be paid solely to the ex-wife whenever she chooses to exercise them.
In general, such an arrangement would be of benefit to an individual who has many years before they will actually retire, and of marginal benefit to those very near to or at their actual retirement age.
While this aspect of maintenance has not been used a great deal in the past, it is an option to be considered. It may be an issue to discuss in more detail with your solicitor.
Earmarking
Under an 'earmarking' order, benefits are notionally segregated for the benefit of the ex-spouse when they come into payment. However, the former spouse continues to 'own' the benefits, and as we will see, this poses many practical problems.
There are different types of earmarking orders available. They can be applied against:
- Pension Income
- Tax-Free Lump Sum
- Death Benefits
As an example, an ex-wife is granted an 'earmarking' order for 50% of her ex-husbands pension benefits when they come into payment.
On the surface, this seems an acceptable outcome. However, consider the following:
- She will only receive the benefits when her ex-husband actually retires and takes the benefits. The Court cannot direct when the ex-husband has to take his benefits. He could defer taking these benefits indefinitely, and she will receive nothing in the meantime.
- The order will lapse if she remarries.
- The order will lapse if her ex-husband dies.
Earmarking orders can be applied separately against Tax-Free 'Lump Sum' benefits, as these can be more beneficial and tangible to the ex-spouse. However:
- As shown above, the Court cannot direct when the ex-husband has to take the benefits; therefore he can postpone taking the benefits indefinitely, which means the lump sum will not be paid out until he physically takes his pension income.
- Unlike the first example, she still may be able to receive her share of the lump sum even if she remarries, depending on the wording of the Court Order.
Death Benefits under a pension scheme (usually Final Salary arrangements) can be earmarked separately, and can be a useful insurance policy for ensuring that maintenance payments be continued in the event of her ex-husbands early death.
- However, previous cases have shown this to be a problematic solution, especially when both parties remarry.
- It is probably much easier for the ex-spouse to take out a separate Term Assurance policy out on the life of her ex-husband (as she still has an insurable interest on his life) for the expected duration of the maintenance period. The cost of paying the premiums for such cover could even be a factor in the maintenance settlement itself. This method is likely to provide more security and a more satisfactory outcome than an earmarking order.
There are also other factors to take into account when considering an 'earmarking' order:
- It will prevent a 'clean break' from being achieved - some ongoing contact will be necessary.
- The order can be varied, and as mentioned above, could cease upon remarriage or death.
Therefore, there are significant risks in implementing an 'earmarking' order, as many factors can arise over time to subvert the original intention of the order and produce a totally different outcome. Saying this, there are some narrow situations where such an order may be necessary:
- The cost of implementing a 'sharing order' (as will be shown below) is excessive compared to the level of pension benefits in question, and could seriously impact upon the pension benefits for both parties, and there are few assets to use for 'offsetting' purposes. [Also, there would need to be some confidence between the parties that the provisions under the earmarking order are likely to be implemented.]
Whilst earmarking was introduced to overcome to drawbacks of 'offsetting', in practise it just creating another layer of problems and difficulties, and in practise has not been widely used.
Pension Sharing
To overcome the shortcomings of 'earmarking', Pension Sharing (also refrred to as 'Pension Splitting') came into force in 2000, and is now widely viewed as the fairest way to deal with pension benefits upon divorce.
This method allows pension benefits to be valued at the time of a divorce, usually on the basis of a current Cash-Equivalent Transfer Value (CETV) and split proportionately as specified in the Court Order.
Once this occurs, the ex-spouse is awarded a 'pension credit', while the member's pension rights are reduced by a 'pension debit'. This allows for a 'clean break' to be achieved, and for the ex-spouse to be financially independent.
However, whilst this method may be fairer than other methods, there is still a lot of complexity and misunderstanding about how to implement sharing orders. Below are several points that need to be taken into consideration when considering going for a 'sharing order'.
- It can be an expensive option. Pension Schemes and Pension Trustees can and do charge fees to implement a pension sharing order, due to the administrative burden involved. A standard cost of implementing a sharing order is c. £750 - £1,000 (plus VAT) PER scheme. Additional charges may also be levied for provision of additional information beyond that originally supplied.
- There may be arguments about who meets the costs of these expenses, and this can be explicitly written into the Court Order.
- If one party has a series of fragmented pension schemes (i.e. Personal Pension Plans, Retirement Annuities and Final Salary benefits), it can be time consuming and costly to request sufficient information in order to analyse them in detail.
- Different types of pension schemes have different types of rules about how a 'pension credit' can be implemented.
- If the member has an entitlement to 'Final Salary' pension benefits, you may want to consider getting alternative valuations to the CETV provided by the scheme trustees.
- It is absolutely essential to take not only legal advice, but also suitable Financial Advice (and possibly even Actuarial advice), as in all likelihood the outcome will involve Pension Transfers. Once the order is implemented, there still remains the question about what exactly to do with the 'pension credit'.
We will look at these in more detail.
Firstly, 'Pension Sharing' is only a viable proposition if the member has pension funds of significant value; otherwise the costs and charges involved could outweigh the benefits of splitting the benefits. The costs involved are at least threefold, as you need to consider:
- Solicitor's fees.
- Independent Financial Advisor (IFA) fees for Pension Transfer Analysis work.
- [Possible Actuarial fees if you require an alternative valuation of pension benefits]
- Costs to implement the sharing order.
Such costs can easily mount up to several thousand pounds, especially if there is a significant amount of work involved. This has to be weighed against the potential benefit of securing a split of the accrued pension benefits.
Secondly, valuing pension benefits can be complex when one party has a collection of different plans and pension rights accumulated over a lifetime. These need to be valued as a first step, but such a jumble of pension arrangements is likely to lead to the following questions:
- Which plan / scheme should the 'pension credit' applied against, and which should be retained by the member.
- What are the costs levied by each scheme to implement a Sharing Order, and do they differ between the different the schemes?
- Do the schemes in question allow internal or external transfers (a topic cover below) or both?
- If the benefits are held within a Final Salary scheme, are there are funding shortfalls within the scheme?
The interplay of all these questions can become very complex, and is usually dealt with by an Independent Financial Advisor (IFA) who is a designated 'Pension Transfer Specialist'. This leads on to the next point, as while most pension benefits are allowed to be shared by way of a 'pension credit', there remain differences between schemes as to how the credit is implemented.
Firstly, lets look at the types of pension benefits that can be shared, and those that cannot be shared.
Pensions that can be shared
- All 'money purchase' pension arrangements (Personal Pension plans, Stakeholder Pension plans, Executive Pension Plans, Occupational Money Purchase arrangements, Retirement Annuity Contracts, Section 32 Buy-Out plans and AVCs)
- Final Salary pension rights
- SSAS (Small Self-Administered Schemes)
- Pensions in Payment (from Final Salary schemes, Annuities, or Pension Fund Withdrawal contracts)
- SERPS / State Second Pension (S2P) pension rights.
Pensions that cannot be shared
- Basic State Pension
- Pre-1978 second-tier State Pension benefits
- Widows / Survivors pension benefits from a previous marriage.
- Pensions already subject to an earmarking order
It may surprise you that SERPS/S2P benefits can valued as a lump sum and be subject to a sharing order. However the above list shows that the majority of pension rights can be subject to a sharing order.
However, as indicated above, how the 'pension credit' can be implemented does differ between different types of pension schemes. Effectively there are two main options:
'Shadow Membership'
This is effectively an 'internal transfer' or reallocation of benefits within an existing pension scheme. The ex-spouse is given her own rights in the scheme that are completely separate from the member. [This should be confused with an earmarking order].
- Many unfunded public sector Final Salary schemes (such as the NHS Pension Scheme) only offer shadow membership.
- Some funded (i.e. corporate) Final Salary schemes allow Shadow Membership, but most do not.
External Transfer Basis
- Most 'money-purchase' plans (such as Personal Pension plans) only offer external transfers on a CETV basis.
- All funded Final Salary pension schemes must allow a pension credit to be exercised by way of taking an external transfer value to a new pension arrangement.
Therefore, in many cases, the choices are clear-cut. Within an unfunded public sector scheme, 'shadow membership' is usually the only option. In other schemes, an external transfer value is usually the only option. However, should a pension scheme offer both options, it can sometimes be difficult to weigh up which is the most advantageous option, and expert advice is essential.
Furthermore, especially when dealing with Final Salary pension rights, there may be questions about whether a Transfer Value done on a Cash Equivalent (CETV) basis actually provides a fair representation of the value of the member's benefits. It is possible for an independent actuary to value benefits using different methods such as the 'Past Service Reserve' method that takes into account the funding reserves with a pension scheme that would be used to cover earnings increases for the member (especially useful if the member is a high earner, or has the potential for large salary and pension increases). Such a valuation may paint a different picture as to the value of the pension benefits as would a CETV. [As always, such an independent valuation comes at a cost - whether this is worthwhile is usually down to a matter of judgement].
It also should not be forgotten that benefits do not need to be split on a 50/50 basis. They could be split 75/25 in favour of the ex-spouse - or any figure up to a 100% split as long as the Court can be presented with evidence as to why such a claim is fair and reasonable. It is often the case that a 'pension credit' taken from a Final Salary scheme by way of external transfer may secure less pension income (assuming a 50/50 split has been done) than the members benefits that have been retained within the scheme. It may be that to equalise the benefits, a different basis of split has to be undertaken (say 62/38 in favour of the ex-spouse).
Is that it?
Not quite. Once it has been decided upon which pension benefits will be split, the levels of split have been agreed, the divorce goes through the court and the decree nisi has been granted, the ex-spouse will be left with one or more pension sharing orders.
However, the orders then need to be implemented. At this point, it is necessary to take further specialist Independent Financial Advice, as the implementation part of the process can be just as confusing as the splitting part.
In England and Wales, the sharing orders are issued by the Court to the Pension Providers / Scheme Trustees. There are many rules and regulations about how the orders should be implemented, but what it boils down to:
- The order must be implemented within a four-month period after being received by the provider / scheme trustee.
- This could be delayed if there are outstanding charges owed to the scheme trustees for implementing the order that have not yet been settled, or if the ex-spouse has not provided sufficient information to make the transfer.
Unless the scheme that the pension credit is being applied against knows where to transfer the money to, they are unable to proceed with the implementation of the order any further.
Therefore, it essential that the ex-spouse (via his/her professional advisors) has already made a decision about where the money will be transferred to; i.e. it could be transferred a new Personal Pension / Stakeholder Pension, an existing Personal Pension, a current Occupational Pension scheme that they are a member of, etc.
It is then necessary to ensure that all discharge forms are completed by all parties involved, relevant personal details about the ex-spouse be supplied to the transferring scheme, and in general monitor the process to ensure that the pension credit be implemented on time and not get bogged down in a sea of red-tape and confusion.
Conclusion
This article has highlighted the main options available with regard to divorce and pension rights.
No single method outlined above is more suitable for all individuals than any other solution, as suitability depends on a multiplicity of factors that will vary from case to case. Whilst 'pension sharing' is now widely viewed as the 'fairest' option available, it is not without its own set of complications and problems.
This is a highly complicated area, and if any of the issue affect you personally, it is absolutely essential to get appropriate legal, financial, and possibly even actuarial advice as soon as possible. Once a divorce has gone through the courts and a decree absolute is granted, it is usually not possible to reverse the outcome, except in limited circumstances. Be warned!
NOTE: This document is intended to provide a brief overview of the subject. It should not be read as a recommendation to use any particular product, as it does not take into account individual circumstances and attitudes.
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