When a couple get divorced their pension benefits may be included in the division of assets and/or income that will take place.
For the purpose of this blog, we will use the following terminology;
We will call the individual who has the pension benefits the member, and,
We will call the individual who may be claiming part of the members pension benefits on divorce the ex-spouse.
The matrimonial causes act 1973 made it possible for the value of pension rights to be the subject of a claim in divorce proceedings.
For divorces commencing since December 2000, 3 methods are available.
· Offsetting
· Earmarking, and
· Pension sharing.
Offsetting Pensions on Divorce
Under offsetting the value of the pension is offset against the other assets of the marriage. The ex-spouse would therefore receive a greater share of the balance of the assets in return for the loss of their share of the members pension.
The theory of offsetting works as follows:
The pension benefits are valued as an immediate asset, i.e. the pension is given a lump sum value in today's terms;
This value is then taken into account when the assets and liabilities of each spouse are considered; and
The “offset” could be accounted for by way of physical assets or by providing some form of income, e.g. the ex-spouse could receive additional maintenance or income or deferred maintenance or a deferred lump sum.
Remember that the division of the assets is not always 50/50 and in some circumstances the pension may be ignored in the calculation altogether, e.g. if the husband and wife both have their own pension provision, or if the marriage was very short.
Where the pension is being offset against other income/ capital, a higher amount may be used as the offset figure to account for any tax liability. Therefore, when calculating the amount to be offset, and allowance for income tax payable on the pension should be made.
There is no impact on either the member or the ex-spouse’s lifetime allowance as there has been no change in the ownership of the pensions.
Offset is made at the time of the divorce. Therefore, neither the death or remarriage of the member, nor the death or remarriage of the ex-spouse has any effect.
However, if a death in service nomination was still in favour of an ex-spouse who remarries, the member may request that this now be overturned.
The valuation of the pension benefits to be offset depends on the type of scheme the member has.
Defined Benefit Schemes
The cash equivalent transfer value (cetv) is used to establish the gross value of the members accrued benefits. For defined benefit schemes, the following is taken into account when determining the amount of offset.
The ex-spouse will no longer gain any benefit from the pension and tax free cash once they come into payment.
The ex-spouse will no longer receives a spouse’s pension if the member predeceases them.
The loss of death in service benefit.
These benefits are paid at the discretion of the trustees and so the ex-spouse would not automatically have received this payment if they have remained married.
Money Purchase Schemes
With a money purchase scheme the loss to the ex-spouse is determined by agreeing a percentage or proportionate division of the fund value, taking the following into account.
Loss of Pension Benefits
The value to the ex-spouse is calculated in the same way as for a pension transfer, the value is based on the cost of buying the benefits accrued to date, and
it takes into account the possibility that they member may die before retirement.
Loss of spouses pension.
Calculated in a similar way as the pension, and mortality tables are used to determine the life expectancy of the member and the ex-spouse.
Loss of death in service lump sum.
Death in service benefits are only paid if the members death occurs before they take their pension benefits from the scheme.
It is not certain that any benefits would have been paid to the ex-spouse as their payment is at the discretion of the scheme trustees who take into account the marital status of the member, the financial dependency of the ex-spouse on the deceased, and any expression of wish completed by the deceased.
Earmarking Pensions on Divorce
The ex-spouse can have benefits earmarked in the members pension scheme allowing them to receive income and/or lump sum payments in the future. This may be on either the retirement or the death of the member.
Under an earmarking award, the member retains ownership of the whole pension fund. The earmarking award simply allows the court to direct the pension provider to pay some of the benefits to the members ex-spouse.
The court can also determine who a lump sum death benefit should be paid to on the members death. If the member can nominate beneficiaries, the court can require them to nominate the ex-spouse to receive part or all of the payment.
Earmarking orders must be expressed in percentage terms. Under a money purchase scheme, this method insures that the ex-spouse will receive a set percentage of the members own pension rights and/or tax free cash.
This will happen irrespective of annuity rates applicable at the time. The order needs to be worded carefully to ensure that the ex-spouse only receives a percentage of the fund to the date of divorce and it's growth, not what the fund value resulting from any subsequent contributions.
Under a defined benefit scheme, the ex-spouse is awarded a percentage of the members pension at the schemes normal pension age. In this instance the unknown is the members defined benefit at normal pension age, as a percentage order picks up a share of future pay rises and these are not easily predicted.
The cash equivalent transfer value method of valuation is used to establish the benefits to be earmarked for an ex-spouse. There is no prescribed method for valuing the death benefits, and these must be identified separately.
There are no taxation issues in respect of the cash lump sum, since it is tax-free. However, in respect of a periodic payment order, the member is deemed to have received the whole pension income and is taxed accordingly.
The ex-spouse is deemed to have received their share of the income from the member and this has the following consequences;
The whole income is taxed at the members marginal rate,
If the ex-spouse pays tax at a higher rate than the member they will not owe any further tax,
If the ex-spouse pays tax at a lower rate than the member they cannot reclaim any of the income tax already paid.
Death in service benefits are taxed as follows.
Any lump sum death in service benefits is pay tax-free,
any death in service spouses pension is subject to income tax, but at the ex-spouse owe marginal rate.
Disadvantages of earmarking Pensions on Divorce
The benefits earmarked for the ex-spouse do not become payable until the member secures their benefits.
The courts have no power to set a date by which the member must take their benefits (i.e. 65) and if the member does defer taking the benefits, which they can do to any age, even beyond age 75, this can have a significant impact on the value of the ear marking order to the ex-spouse.
Pension benefits with a earmarking orders attached to them may be transferred from one scheme to another.
The ex-spouse has no control over this, it is entirely the members decision.
Where all the benefits are transferred, the ex-spouse is notified by the original scheme so that they can apply for a variation of the original order.
However, where only part of the benefits is transferred the order does not transfer to the new scheme and the ex-spouse can only claim against the original scheme.
This means they must claim the balance owed from the member.
It is easy for the ex-spouse to lose track of the ear marking order, particularly if they change address, because the scheme is only required to write to them at the last known address.
The ex-spouse has no control over the members investment decisions.
This means that the member could invest their funds in a manner contrary to their exposes attitude to risk.
The use of an earmarking award can lead to issues upon death or remarriage.
While earmarking offers an alternative to offsetting it goes against the principle of a clean break on divorce.
Advantages of Earmarking Pensions on Divorce
Earmarking does have some advantages for the member, including
no money or assets change hands at the point of the divorce
If the member remarries, their new spouse and/or other dependents may benefit on their death because any periodic payment order to the ex-spouse will cease
if the ex-spouse dies before, or soon after, benefits commence then any periodic payment ceases and the member will receive their full pension benefits
if the ex-spouse remarries the periodic payment order will lapse,
The member has full control over the timing of benefits where the funds are invested and any decision to transfer benefits.
Impact on the lifetime allowance
Earmarking has no direct impact on either the member or the ex-spouses lifetime allowance as the pension benefits remain in the ownership of the member, i.e. neither will have an adjustment made to their lifetime allowance. However, an earmarking award can have an indirect impact.
The member will have a lower pension income in retirement but, because they still own all the pension rights, these rights, including the income and/or lump sum paid to their ex-spouse, will be valued against their lifetime allowance.
Where a member has pension rights that are valued at close to the lifetime allowance this gives them no scope to fund a pension to replace this income without risking a lifetime allowance tax charge.
The ex-spouse will receive a pension income that is not valued against their lifetime allowance, so they can fund pensions of their own to the value of the lifetime allowance + received the benefits under the ear marking, without paying a lifetime allowance tax charge.
Pension sharing Pensions on Divorce
Pension sharing divides the scheme members pension rights at the time of divorce;
The split is not necessarily 50/50
The ex-spouse may be entitled to a transfer value and/or membership of the members pension scheme
The amount of the sharing order is expressed as a percentage of the members fund (if money purchase) or in terms of the benefits to be received (if defined benefit).
The following pension rights cannot be shared;
New state pension
Basics state pension
State graduated retirement benefit
A widow's pension in payment
The following pension rights can be shared
Protected payments paid in addition to an individual's entitlement to the new state pension
SERPS and S2P
Occupational schemes, including avc's
Registered individual schemes,
Statutory schemes
When pension benefits are shared, they are passed irrevocably to the ex-spouse. Therefore they are taxable as part of the ex-spouses income in retirement and the member is only taxed on the benefits they actually receive.
Because pension sharing achieves a clean break, the death or remarriage of either party has no effect on the sharing order. If the ex spouse dies, the benefits will become part of their estate and not revert to the member.
The treatment of the share for the ex-spouse depends on whether the scheme is funded or unfunded and whether it is money purchase or defined benefit.
Funded money purchase scheme
The courts will award a percentage share of the money purchase fund EG 30% of £100000 fund would result in £30,000 of the fund being given to the ex-spouse.
Following on from this one of two things can happen.
The ex-spouse could transfer the £30,000 to their own occupational scheme or to a personal pension,
The original scheme can, but does not have to, offer the ex-spouse membership, so that the value is retained within the members scheme, but in the ex-spouse his name.
Funded defined benefit schemes
The award is based on a percentage of the cash equivalent transfer value (cetv) at the date of the pension sharing order.
The defined benefit scheme may impose a more restrictive age band for retirement if benefits are retained in the scheme (i.e. between the ages of 60 to 65 rather than 55 to 75). It may also impose penalties if benefits are taken before the schemes minimum pension age.
Note that the option of a transfer value must be offered to the ex-spouse, where is membership of the scheme does not have to be offered. In reality, many schemes will choose not to offer membership because of the administrative inconvenience of accepting new members, who often have relatively small pension rights.
Unfunded schemes
These are defined benefit pension schemes that do not have a pension fund and so retired members benefits are, technically, paid from current member contributions. These schemes include public sector schemes, such as the Civil Service scheme.
For these schemes, pension sharing works in the opposite way to a funded defined benefit scheme.
Although these schemes could, theoretically, provide a transfer value they are not required to do so on the basis that the scheme could be adversarially affected,
They do have to offer membership of the scheme.
Advantages of pension sharing Pensions on Divorce
Advantages to the member
They potentially lose less value than if offset or earmarking orders have been used
It provides immediate settlement and a clean break
There are no income tax implications for the member, so a lower gross value can be given up
Advantages for the ex-spouse
Benefits cannot be forfeited in the event of either parties death
There is no risk on remarriage or cohabitation
It provides immediate settlement and a clean break
What happens to Pensions on Divorce – The Bottom Line
The topic of pensions is generally a complicated subject in itself, however the topic of what happens to pensions on divorce is an extremely complicated area, and therefore expert financial advice should be sought in order to ensure you both make an informed and appropriate decision.