27 February 2020

How to split the pension on divorce

It is twenty years since the family courts in England and Wales were given the power to share pensions on divorce (Welfare Reform and Pensions Act 1999).

This blog post was first published in the FT Adviser and can be accessed here.

This is a unique power, and is the only circumstance in which a living individual can transfer all or part of their pension fund to another individual.

When a divorcing couple apply to the court to resolve the financial aspects of their divorce, the court has the power to make a wide range of orders, for sale or transfer of property, for payment of lump sums and regular monthly maintenance. In appropriate cases, the court can make a Pension Sharing Order (PSO). Such an order may be imposed by the court following contested proceedings, but more usually it will form part of an order made by consent following a settlement negotiated by the parties with the assistance of lawyers or a mediator. The universal valuation method for pensions is the Cash Equivalent

A PSO is an order directed to the trustees of a pension, requiring them to transfer all or part of the pension fund to the holder's ex-spouse. Together with the order, the trustees will be served with a Pension Sharing Annex, containing specific instructions, including the percentage of the value of the fund which may be transferred. It is possible for PSOs to be made against more than one pension, in different proportions.

Pensions in divorce settlements

In the twenty years that the family court has had the power to share pensions on divorce, thousands of pensions will have been divided, and thousands more will have been offset against other assets as part of a divorce settlement. A financial settlement on divorce is always a compromise, balancing the needs of the individuals concerned and their children, in both the short and the long term. The ability to share or offset pension assets can provide welcome flexibility, and can help structure a settlement in a way that is tax-efficient.

However, pensions are complex instruments. They can be difficult to value, and even more difficult to compare with other assets on a like-for-like basis.Family court judges, divorcing couples and their lawyers frequently have to make decisions under pressure, with consequences that will not play out in full for many years. A pension pot, accumulated over many years and representing an aspiration to a comfortable retirement, can be very difficult to give up, particularly in an acrimonious divorce, despite potential tax incentives to do so. It is telling that an alleged failure properly to understand pension assets is the largest source of negligence claims against family lawyers.

However, an eagerly awaited report by a group of legal and financial experts has highlighted some of the pitfalls, and provides useful guidance in this complex area. It is fair to say that pension sharing is one of the less well-understood aspects of matrimonial financial practice. In a most welcome development, Sir James Munby, the former President of the Family Division, convened an inter-disciplinary working party to investigate how pension sharing works in practice in the family courts, to highlight difficulties, and to make recommendations to improve inter-disciplinary working, the Pension Advisory Group (PAG).

The PAG's report, "A Guide to the Treatment of Pensions on Divorce" was published in July 2019.

Valuation

The universal valuation method for pensions is the Cash Equivalent (CE). A divorcing couple will inevitably be required to obtain CEs for each pension scheme of which they are or have been a member. A PSO will be expressed as requiring the trustees to transfer a proportion of the CE value to the other spouse. The advantage of CEs is that they are easily obtainable, and provide an approximate "snapshot" value of a pension fund.

The difficulty is that the CE can provide a wildly inaccurate valuation, in some circumstances. The CE, which will be calculated by the trustees of each scheme in accordance with their own rules, is a calculation of the cash sum that the scheme will pay to discharge their obligation to pay income in retirement. The value of the pension benefits to the individual member may be very different, and it may cost far more to purchase equivalent benefits on the open market. This can be important in a divorce context, where using only CEs can produce unfair outcomes.

For example, a couple each age 40 where the self-employed husband has a Defined Contribution pension with a CE of £150,000 and the teacher wife has a final salary Defined Benefit pension with a CE of £150,000. On the face of it, the pensions are of equivalent value. In practice, the wife's teachers' pension will provide a guaranteed tax-free lump sum and guaranteed pension, plus a widowers' pension. If the husband were able to purchase equivalent benefits on the open market, the cost would be significantly higher than £150,000.

The PAG strongly recommends that suitably qualified experts should be instructed far more frequently to assist couples and the courts in valuing pension assets.

Offsetting

The Pension Advisory Group concludes that relatively few PSOs are made.

Instead, in the majority of cases, pension assets are dealt with by way of offsetting. In effect, one party's pension is traded for a greater share of non-pension assets.This is very frequently the situation in a "needs" case. Stereotypically, and very frequently, where there are young children, a non-working wife will retain the sale proceeds of the family home, to enable her to re-house without a mortgage. The husband will retain his pension and business assets and will use his mortgage capacity to re-house. In such a situation, it is unlikely the value of assets retained by the husband will come close to those retained by the wife. The value of his pension is of little relevance, and there is little need to focus on the value to be attributed to it for offset purposes.

There will be occasions, however, where pensions form a significant part of the family assets, where correct valuation of the pension for offset purposes will be key. In addition to the known difficulties with CE values, it will also be necessary to factor in the cost to the pension holder of extracting benefits. Other than the 25 per cent tax-free lump sum common to most pensions, funds drawn down from a pension will be subject to income tax at the recipient's marginal rate.

There is a longstanding debate as to whether offset values should be further discounted for "utility". In other words, whether a liquid asset is more valuable than a pension, which represents a future income stream.

The PAG is sceptical as to whether such a discount for utility is ever appropriate, while accepting it may on occasion be necessary as an encouragement to settlement. The PAG highlights concern in the industry that offsetting is often considered the default position, perhaps because parties, their lawyers or even judges are reluctant to grapple with issues of pension valuation. They point out that a failure properly to understand pension assets is the largest source of negligence claims against family lawyers. In some cases, pension sharing can be a helpful, and tax-efficient aid to settlement.

A party who is likely to reach their lifetime allowance (£1,055,000 in 2019/20) before retirement, can transfer all or part of their pension pot to a spouse as part of their divorce settlement, up to the spouse's lifetime allowance. The transferor then has the opportunity to re-build their pension pot, taking advantage of tax relief.

However, the recent reduction in the annual allowance will reduce the number of individuals for whom this is a viable option. Those considering this option need to be aware that the valuation used for calculating the Lifetime Allowance is not necessarily the same as the CE, particularly in the case of Defined Benefit schemes. The so-called "pension freedoms" have introduced an element of flexibility into the treatment of pensions on divorce.

In certain situations, it can be helpful for one party to be able to release capital (perhaps to help fund a property purchase), or to draw down funds from a pension to supplement income from employment of maintenance. However, there are potentially serious pitfalls for the unwary. For instance, it is all-too easy inadvertently to trigger the Money Purchase Annual Allowance (MPAA), thus reducing the amount that can be reinvested into a pension to a maximum of £4,000 per year.

The PAG once again emphasises the need for parties to seek professional advice before seeking to use pension sharing as part of an overall financial settlement.

Advice

The PAG repeatedly urges that parties seek specialist advice in relation to this complex area. Failure to do so can have very serious consequences. However, the PAG notes that there is no clear means of identifying who is qualified to give such advice. There are acknowledged experts in pensions on divorce, among them some actuaries, financial planners and independent financial advisers.

In the absence of a specific accreditation, the PAG suggests that a proposed expert should be asked to sign a statement of truth, in effect self-certifying that they have the requisite expertise, that they have systems in place for peer-review and handling complaints, and suitable insurance. The PAG report provides fascinating insight into the treatment of pensions on divorce, and highlights a significant number of issues requiring further consideration or reform. Twenty years after the introduction of pension sharing, it feels like a first step in dealing with many of the complex issues the legislation has thrown up.

Simon is a partner in our Family team.

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