Pensions and divorce

Hi and welcome to this pension’s technical video on ’Pensions and divorce and the effect of the pension freedom reforms’. There are three means of dealing with pensions in the event of divorce - the first one being offsetting.

Now offsetting is the most frequently used method of dealing with pension benefits on divorce. The value of the pension assets is taken into account in valuing the couple’s assets, but they both keep their own pension rights with the value of the pension rights being offset against other assets, such as savings or investments or the value of the family home.

When offsetting is used, courts assess non-pension capital, pension assets and income when deciding how to share a couple’s assets. But the pension freedom reforms mean pensions can be taken as a lump sum, can be used to buy an annuity, or can be accessed via drawdown or by combination of all three. Prior to the pension freedom reforms these categories of wealth were quite distinct but now there is a blurring between capital and pensions which gives the court greater flexibility, but makes it much more difficult to predict what a judge is likely to do.

Another way offsetting may be impacted, is that prior to the implementation of the pension freedom reforms, a common method was to discount the value of a pension because of the uncertainty of the true eventual value of the pension. This was especially the case due to the illiquidity of annuities already in payment. However, now for divorcees over age 55, there is complete access to defined contribution pension funds which means there is less of an argument for discounting.

The second method of dealing with pensions in the event of divorce is earmarking. Earmarking is effectively a form of deferred maintenance payment, where all or part of the pension benefits of one of the divorcing couple (the member) are ordered to be paid to their ex-spouse or ex-civil partner when the member accesses their pension benefits.

Earmarking orders may also be made against a member’s tax free pension commencement lump sum and in respect of lump sum death benefits. Many earmarking orders were drafted at a time when the pension freedom reforms were never envisaged and unless the details in the order are very specific, these new pension freedoms can have unintended consequences of circumventing the requirements set out in the order by way of the member cashing their pension in and not taking a pension income.

So for example, if the earmarking order doesn’t specify exactly when and how benefits must be taken and/or doesn’t specify a requirement to take the tax free cash or PCLS, then the order can be circumvented by taking an Uncrystallised Funds Pension Lump Sum (an UFPLS)  which doesn’t by its very nature include a PCLS. Then if there are no pension funds left to crystallise, there is no income left to be covered by an income earmarking order. It is therefore worth revisiting clients who have an earmarking order enforced and if necessary to return to the court to get the orders intention clarified. There are no time restrictions on doing this though inevitably there is an element of cost involved. 

In Consultation Paper 15/30 entitled ’Pension reforms proposed changes to rules and guidance’, which was issued in October 2015, the FCA consulted on the issues around pension attaching and earmarking orders. In Policy Statement PS 16/12 entitled ’The FCA’s feedback to the responses it received on SP 15/30 and final rules and guidance’, the FCA responded by stating that ultimately it is for the courts to vary any attachment or order that may not work as intended should the member take advantage of the pension freedoms to access their pension benefits, and that their guidance will help ensure that attachment orders are taken into account by both providers and advisors. 

The third method of dealing with pensions in the event of divorce is pension sharing. With pension sharing, part of the member’s pension is passed to their ex-spouse or ex-civil partner.

In general, a pension sharing order will be expressed as a percentage of the members cash equivalent transfer value under his or her 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 or ex-civil partner. Depending on the scheme providing the members’ benefits, the pension credit may either be used to provide benefits for the ex-spouse or ex-civil partner under the member’s scheme or be transferred to a suitable registered scheme of the ex-spouse’s or ex-civil partner’s choice. 

Many private sector pension schemes will only allow transfer out but where the member’s scheme is an unfunded statutory scheme such as a civil service scheme or the teacher’s scheme, the only option available to the ex- spouse or ex-civil partner will be to retain benefits within the scheme. As a result of the pension freedom reforms the ex-spouse or ex-civil partner may prefer to have a cash lump sum rather than a share of the pension fund. If the member is over age 55 then this is possible even if the ex-spouse or ex-civil partner is much younger. The courts may therefore decide that an Uncrystallised Funds Pension Lump Sum (UFPLS) or a series of UFLPS should be paid instead of pension sharing. However, it’s worth noting that this could potentially result in serious tax implications for the member. 

There are a number of things to watch out for when seeking to take advantage of the pension freedom reforms. In the case of occupational money purchase schemes accumulated pre A-Day, there can exist protected retirement ages, otherwise the ability to retire from age 50, an enhanced tax free lump sums which will be lost on transfer unless a block or bulk transfer occurs. There is also the distinct possibility that scheme trustees will be unable or unwilling to facilitate pension freedom especially if the member is still an employee. 

Personal pensions are not exempt, guaranteed annuity rates, market value reductions on with profits funds and transfer penalties on some commission based schemes, mean that an early exit in order to access a pension flexibly could have punitive consequences. 

The other main areas of concern revolve around the tax consequences of liberating pension monies and the effect on state benefits. With the exception of the tax free lump sum, all other withdrawals from a pension are taxed as income. Therefore a significant withdrawal could attract income tax at a higher rate than the relief on the original contribution, especially where the total income for the year exceeds £100,000, resulting in the reduction or loss of the personal allowance. A withdrawal that pushes income over £50,000 in the tax year will also cause a reduction or a loss in child benefit. 

The final matter to be aware of is where a client uses the new rules to access a lump sum over and above their PCLS from their pension, doing so triggers the MPAA and as such their annual allowance could be reduced from the current £40,000 to £4,000, which will have a significant effect on their ability to place future monies into a tax advantaged wrapper. 

Thank you for watching.