Pensions and Divorce
Until 1996 it wasn’t possible to share pension benefits on divorce, they could only be dealt with by offsetting other assets against their value. In July 1996, following the Pensions Act 1995, earmarking or attachment orders were introduced. It wasn’t until December 2000 that we were first able to get a clean break as well as share the pension, when pension sharing was introduced. In this factsheet, we will consider each option in turn, including the pros and cons to consider. There is no one right answer with regards to pensions and divorce and all options should be considered when giving financial advice.
This is the oldest 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 both keep their own pension rights with the value of the pension rights being offset against other assets. For example, if one spouse has the greater pension provision, they might keep that with the other spouse keeping the family home and other assets being used to ensure a fair overall settlement.
Earmarking became available for divorces petitioned (started) on or after 1 July 1996. The idea is that at the point of payment, a certain percentage of the member’s benefits in their pension is taken and paid to the other party instead. But the arrangement itself isn’t split and continues to belong to the member. 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.
As the earmarked benefits for the ex-spouse are treated as part of the member’s benefits, the pension paid to the ex-spouse will be taxed at the rate appropriate to the member.
The main downfalls of earmarking are that:
- The funds are taxed on the original member and not on the ex-spouse;
- The member still has control over the investments made and the timing of accessing the benefits; and
- The earmarking order will cease to be effective in respect of pensions income if the ex-spouse remarries or enters into a civil partnership
- The court order could include restrictions on the member’s choices to transfer and when they retire, which will impact the member in the cases of attachment orders for less than 100%
Pension sharing is available for divorces petitioned on or after 1 December 2000.
With sharing, pension is passed from one member of the couple to the other. In general, a pension sharing order will be expressed as a percentage of the member’s cash equivalent transfer value under his pension scheme. 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.
Depending upon the scheme providing the member’s benefits, the pension credit 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. Many private-sector pension schemes will only allow transfer out, but where the member’s scheme is an unfunded statutory scheme the only option available to the ex-spouse will be to retain benefits under a public sector scheme.
Pension sharing is often seen as the cleanest way to split a pension on divorce, although it is probably the most complex initially. It does provide a lot of positives such as:
- A clean break – once in place and the ex-spouse has taken the necessary steps to instruct where their credit is to be moved to; the ex-spouse is in total control of the pension they have been awarded and the member is free to deal with any remaining benefits under the terms of their arrangement
- The pension credit doesn’t revert if the ex-spouse remarries.
- All investment decisions are now the responsibility of the ex-spouse.
- Timing of benefits can’t be dictated by the original member or their age.
- Taxation of benefits is based upon the person who will actually be receiving them.
Implications of the options on Lifetime allowance and protections
Offsetting will have no impact on the pension protections, or lifetime allowance of either party involved because the pensions will not change ownership, so in terms of complexity this is the simplest of all the options. However, both earmarking and sharing will have an impact on the available lifetime allowance of each party.
With earmarking the funds remain with the original owner and are tested against their lifetime allowance. This means that the benefits they can build up will effectively be restricted whilst leaving the other receiving spouse scope to build up pension benefits in their own name, against their own lifetime allowance.
There is more to consider when thinking about pension sharing because the pension credit moves from the member’s name to the ex-spouse and so there are knock on implications to for the lifetime allowance.
Any pension credit created after 5 April 2006 will be tested against the ex-spouse’s lifetime allowance when they crystallise, all credits received after this date are deemed to be uncrystallised even if benefits were already in payment and should be recorded so. However, for pension credits derived from benefits in payment, the benefits options will be restricted to remove the option of a pension commencement lump sum.
In addition, where the pension credit is derived from pensions in payment that have already been tested against the lifetime allowance of the member then the ex-spouse is entitled to claim a lifetime allowance enhancement equal to the amount received. This is to ensure that the same monies are not potentially subject to lifetime allowance tax charges twice.
A special transitional rule applied so that where a pension sharing order was in place at 5 April 2006 the ex-spouse could elect by 5 April 2009 for an enhanced Lifetime Allowance in respect of the pension credit. Although this option isn’t now available it is worth noting that clients in this situation may already have an enhanced lifetime allowance.
Any pension debits that occurred before 6 April 2006 will not have an impact on the lifetime allowance of the member because it only takes account of actual benefits paid.
In the majority of cases, a pension debit will not impact Fixed Protection of the member, and the receipt of a pension credit should not cause the loss of fixed protection for the ex-spouse if it is paid into an existing arrangement of the ex-spouse. However, if the member starts to rebuild their pension, they will normally invalidate their protection.
For those receiving large pension credit, especially in excess of the current lifetime allowance, it may be beneficial to apply for fixed protection 2016 provided they met the requirements in 2016 and still do. This means that the ex-spouse should not have made any contributions after 5 April 2016, but more importantly, they needed to have some pension in their own name.
However, care should be taken with regards to setting up a new arrangement for the ex-spouse to receive their pension credit, as this is likely to cause them to lose their fixed protection (or make them ineligible to apply for it).
A pension debit could cause the member to lose their individual protection. Effectively, the value of the debit, reduced by 5% for each complete tax year between the pension debit and 2014/2016 as appropriate, is rolled back to the relevant date (5/4/2016 or 5/4/2014) and once deducted, if it takes the benefit value below the minimum protection value, the protection will be lost. Even if it isn’t lost it will be recalculated, and potentially reduced.
In much the same way as individual protection, primary protection from 5 April 2006 could be lost or reduced because of a pension debit. However, when considering primary protection there is no reduction to the pension debit, it is the actual monetary value of the debit that is deducted from the individual protection amount to determine the new figures. It is worth noting that if primary protection also had associated tax-free cash protection then this wouldn’t be recalculated, although it will be lost if primary protection is revoked because of the size of the debit.
Much the same as with fixed protection, enhanced protection won’t be impacted by a pension debit. However, where the member has a defined benefit scheme that they opted out of before 6 April 2006 which has now been subject to a pension debit, there could be scope for them to re-join the scheme if they are still eligible. Care should still be taken to ensure that relevant benefit accrual doesn’t occur but the calculations will be based on the pre debit figures at 5 April 2006. Also, care should be taken where someone with enhanced protection receives a pension credit, as if a new arrangement is set up to accept the pension credit, this will normally cause them to lose their enhanced protection.
Practical issues of dealing with divorce cases
As we know, not all pensions are equal, they come with a variety of benefits and in a variety of structures. For a simple money purchase scheme, it could be easy just to take the value as given but with differences in life expectance, age and health then even a simple pension can become difficult to split. In all but the simplest of cases an expert report can add significant value in determining what is the best and fairest outcome. The reports often won’t make a recommendation but will give the various options available to help decide which route to choose.
Reports are usually provided by Actuaries or Financial Advisers who specialise in this area and can be instructed jointly or by individually. All experts are likely to use different assumptions, so it should be borne in mind that the outcomes of the reports may therefore differ if instructed on an individual basis and may therefore cause more confusion.
The manner of calculating CETV differs between divorces in England and Wales divorces in Scotland, with Scottish divorces having the ability to establish a value by reference to the dates of marriage. A valuation under Scottish law may need to be specifically requested.
It is essential that a provider be told about the likelihood of a pension sharing or pension earmarking order being made or that a pension sharing or pension earmarking order has been made, as soon as possible.
If a pension sharing order is made against an arrangement which already no longer exists because benefits have been transferred or crystallised the order cannot be implemented against the arrangement.
If the provider facilitates a transfer of benefits already subject to an pension sharing order that they did not know about, the order cannot take effect or be implemented against the plan which no longer exists, nor will it follow the benefits to the new arrangement or provider.
In either event, the parties would need to return to court to seek an order against the arrangement currently holding the benefits.
If an earmarking order is made against an arrangement which no longer exists because benefits have been transferred or crystallised before the order is made, the earmarking order will fail to take effect.
If an earmarking order has been made but not notified to the named provider and the provider facilitates a transfer of benefits, the earmarking order could in principle follow the benefits but is a new provider is not advised of it within a prescribed period, they are not under an obligation to record the earmarking order or implement it at crystallisation and the parties may need to return to court.