Going through a divorce is a difficult time, both emotionally and financially. Les Cameron, Head of Technical at Prudential, discusses how good financial advice can bring benefits, not only when splitting the marital assets, but also in the future when retirement takes place.
It’s important to understand the mechanics of sharing marital assets, and how tax rules and pensions legislation would apply. Some key points are:
- What are the options for sharing pension benefits following divorce?
- What are the extra considerations for pensions already in payment?
- What plans can be made for who will benefit from shared pension rights on death?
Options for sharing pensions
There are three ways pensions can be dealt with on divorce: offsetting, attachment (earmarking) order or pension sharing order.
Offsetting involves getting the value (usually the cash equivalent or transfer value) of the pension benefits as at the date of the divorce. This value is added to the total value of other matrimonial assets to be divided between the parties.
Pensions are valued differently depending on where the divorce is taking place, e.g. in Scotland a pension is viewed in the same way as any other investment. Basically £1 in a pension is valued in the same way as £1 in an ISA. There is no factoring in of the eventual tax treatment when benefits are taken (i.e. usually only 25% of a pension is tax-free, whereas an ISA is entirely tax-free). Also, no account is taken of when the pension can be accessed, so for divorces where one (or both) parties is below minimum pension age, the £1 for £1 valuation may create issues.
In England, Wales and Northern Ireland, pensions are not valued as any other investment, so the solicitors dealing with the divorce may need to engage the services of an actuary to determine the value of the pension rights in today’s terms for the divorce.
Once the value has been decided, the ex-spouse gets a share of another asset instead of a share of the pension. For example, the ex-spouse may retain the family home, or at least a larger share of its value, to compensate for the value of the pension assets.
An attachment order (also commonly referred to as earmarking) is effectively deferred maintenance. This option does not allow a clean break between the divorcing parties and is less common since the introduction of pension sharing, which is allowed for divorce proceedings started on or after 1 December 2000.
The court uses a cash equivalent basis for the pension benefits. All pension benefits may be taken into account, except any already earmarked from an earlier divorce.
In England, Wales and Northern Ireland, the benefits that can be earmarked are:
1. A specified percentage of the pension benefits when the member starts to draw their benefits
2. A share of the lump sum available when benefits are accessed
3. A specified percentage of any lump sum death benefit in the event of death of the member before retirement
In Scotland, only 2 and/or 3 can be earmarked.
There are several disadvantages with earmarking, mainly that the ex-spouse has no control over when benefits are taken or what investments the fund is in, and regular payments usually stop if the receiving ex-spouse remarries or if the pension-holding member dies.
Pension sharing order
Pension sharing separates the ex-spouse’s pension entitlement from the member’s pension, giving a clean break. The court decides how much of the pension rights should be allocated to the ex-spouse and the member’s benefits are reduced by the corresponding amount.
Existing pension annuity income, scheme pensions in payment and most drawdown pots can be shared. Any dependant’s, nominee’s or successor’s drawdown pots cannot be physically shared under an order, although the value of the pot may be taken into account when reaching the divorce settlement.
Three considerations for sharing a pension already in payment
Beware of restricted options for any tax-free portion
A pension transfer paid from previously crystallised funds is a ‘disqualifying pension credit’. This is uncrystallised funds, but with the caveat that none of it can be paid as a pension commencement lump sum, or an uncrystallised funds pension lump sum.
Where scheme rules permit, a disqualifying pension credit can pay a serious ill-health lump sum, and on death before taking any benefits, it can be settled as an uncrystallised lump sum death benefit, both subject to the usual LTA rules.
Is the ex-spouse eligible to apply for a Lifetime Allowance enhancement factor?
A pension credit factor increases the pension credit member’s personal Lifetime Allowance limit.
An individual qualifies for a pension credit factor, if they receive a disqualifying pension credit on or after 6 April 2006 from a pension scheme where the original member became entitled to the pension in payment on or after 6 April 2006.
Where eligible the individual has to apply to HMRC within a specified deadline, following the sharing order taking effect.
Has the ex-spouse reached minimum pension age?
Although one party has a pension already in payment, perhaps they are several years older than their ex-spouse, or maybe they had a protected early pension age due to their occupation, e.g. armed forces, deep-sea diver etc; this does not mean the recipient of the pension credit can have immediate access.
When an individual receives a pension credit, they have to reach normal minimum pension age or satisfy the ill-health rules before they can take any benefits. If there is a need for immediate income, then an attachment/earmarking order may be a better solution. However, if the pension-holding member is a higher rate taxpayer and the ex-spouse is a non- or basic-rate taxpayer, this could mean less cash for the ex-spouse.
Important planning on who will receive benefits on death
At the point of separation, it may be prudent to consider making a will and updating the expression of wish for any existing pension arrangements, to make sure that current wishes are clear.
In relation to the expression of wish form, a separated spouse is still technically a dependant in HMRC terms. Where a pension scheme is set up on a discretionary basis, the scheme administrator will gather relevant information before deciding who should benefit. An up-to-date expression of wish form will help them with their decision-making.
If a pension credit is set up in a separate defined contribution scheme which can offer the flexible death benefit options, i.e. dependant’s/ nominee’s drawdown, then also complete an expression of wish form for that scheme and keep it up to date. This is especially important when there may be a dependant at the date of death and children who have reached the age of 23 who are to be considered beneficiaries. If older children are nominated, it means the scheme administrator can offer them the full range of death benefits available. If someone with three children (ages 25, 21 and 18) dies with no expression of wish form, then the two dependent (younger) children could receive dependant’s drawdown, but the child over 23 would only be entitled to a lump sum.