Pensions and divorce - how are pensions treated when a marriage breaks up?
Monday 5th July, 2021
"Do pensions form part of the marital assets?"
This is a question I am frequently asked by clients who are unfortunately getting divorced. It is a really important question, as pensions are often the most valuable asset that has been built up during the course of a marriage, quite frequently worth more than the couple's house. Unfortunately, these are assets that are also frequently ignored in divorce discussions and the final financial settlement, leaving at least one of the parties in an unenviable position when it comes to funding their retirement in the future.
In the article below, I will discuss which pension benefits may be taken into consideration when getting divorced, how they are valued and the options available when dividing the benefits between the two parties.
Pensions and divorce
One of the key assets built up during a marriage are the pension assets. These can consist of State Pension benefits, Final Salary pension schemes and Defined Contribution schemes built up through employment and personal savings.
The focus of these schemes is generally to provide an income in retirement. The pensions are often the foundations upon which a couple builds their joint retirement dreams and goals. In many cases, pensions are the most valuable assets couples possess, often being worth more than their house.
It is not unusual for one spouse to build up a far more substantial pension pot than the other. This may be because one spouse sacrifices their personal career goals in order to look after children or to provide support for the other spouse’s career ambitions. This means that one partner is left at least partially dependent on the other’s pension provisions to provide for their retirement.
This is absolutely fine where the couple remain married/together and are able to use the pension to provide for their joint retirement. Unfortunately, this is often not the case. In many circumstances, the marriage ends in divorce and the couple are forced into splitting the marital assets.
The issue of how to share the pensions is a key consideration when a split occurs and can often be one of the most complex matters of the divorce. In the next few paragraphs, I would like to consider which pensions are included within the marital assets, how they are valued and the options for splitting the pensions between the divorcing couple.
In the article below, I am using the term marriage to refer to both marriages and civil partnerships. I understand that there are differences and I hope not to offend anyone. However, I have done this simply to ensure that the wording in the article is no overly cumbersome and that it reads well.
Do pensions form part of the marital assets?
In England & Wales, all pension rights belonging to either party (other than those specifically excluded) will normally be treated as marital assets. This includes entitlements to the earnings-related element of the old State Pension (SERPS or S2P) and any protected payment under the New State Pension.
This is highlighted by the fact that the Form E financial statement each of the parties are required to complete if the court becomes involved, requires details of pensions.
There are a few pension rights which are excluded from the joint marital assets and this includes:
- The Basic State Pension
- State Graduated Pension
- The New State Pension (except for any protected payment element)
- Any survivor’s pension being paid following the death of a former spouse or civil partner.
Valuation of pension rights
The state has provided rules which dictate how certain pension rights should be valued for the purposes of splitting the assets during the dissolution of a marriage or civil partnership.
Despite this, there remain a number of difficulties and pitfalls when it comes to valuation of pensions. And one of the problems with including pension assets in a divorce settlement is that it can be really difficult to see a current value in what is often considered to be a future asset, as the benefits do not become payable until the member dies or retires.
So, what we're trying to arrive at is the cash equivalent value of the pension assets. For Defined Contribution (DC) pensions, it's pretty straightforward. It's the fund value. But there are some nuances here which not everyone is aware of.
It is important to note that many DC pensions may have valuable guaranteed annuity rates, protected growth rates and protected tax-free cash, that may be lost if the pension is shared. This is particularly true of pensions and Retirement Annuity Contracts set up in the 1980s and early 1990s.These will naturally affect how valuable the pension benefit is, and it may be argued that it is better to use offsetting of assets (see below) in order to allow the member to retain the pension benefit.
And then, you also need to consider whether any loyalty bonuses or terminal bonuses have been taken into account in the fund value, because they should be. These are normally available when With Profit funds are involved and can make a substantial difference to the value of the pension benefits.
for final salary or Defined Benefit (DB) arrangements, they're much more difficult to value, and these include most of the large public sector pension schemes, such as the police, fire brigade, army, civil service, NHS and teacher schemes.
Now, the cash equivalent value for DB schemes must be calculated by the scheme actuary. Now, although these are qualified professionals, they still have to make assumptions, which are basically professional guesses as to what the future pension may be. Therefore, there is a lot of scope for variation of these cash equivalent values.
So, how do the scheme’s actuary calculate the cash equivalent value in the first place?
- Firstly, they get the basic pension income that then gets projected to scheme retirement age using a revaluation factor.
- Then, an annuity factor is applied to work out the market cost of buying that pension income at the scheme retirement age.
- Lastly, a discount factor is applied, to work out the cost in today’s terms.
Now, each one of these stages require the scheme actuaries to make assumptions that can be questioned. This can result in a substantial difference in the actual value given to the pension benefit for the purposes of the divorce and sharing of pension assets.
for the basic pension it is important to take into consideration where members can get early access to their benefits without any actuarial reduction, for example pensions offered by the uniformed services. If this is the case, then if the benefits are going to be taken early, this means they'll get paid for longer and therefore the valuation should be taken at the earlier start date, as this will provide a more accurate and a higher valuation.
It is also important to consider some occupations where individuals may have clearly defined career paths where they will receive future promotions perhaps just based on the length of time that they have been there, like the armed forces.
It is often difficult to query the revaluation factor as it's normally a statutory rate that’s used, such as CPI or RPI. The factors that are more likely to be successfully challenged are the annuity factors and the discount factor. The annuity factor is unlikely to account for impaired life and also typically assumes the spouse is three years younger. But what happens if the spouse is much younger? Well, that would impact on the annuity rate. Many DB schemes offer a 50% spousal pension. In order to provide a 50% spousal pension for a younger person generally requires more money to achieve a specified level of income, thus resulting in a higher value of the pension benefits.
If we look at the discount factor, that’s calculated by the scheme actuary and it is perfectly feasible that they could undervalue the benefits, as they're trying to be mindful of other members. In these cases, it may be beneficial to employ a consultant actuary to recalculate the figures. Or you could get the consultant actuary to speak to the scheme actuary to come up with a compromise for the cash equivalent value.
Now, it is very Important to highlight that the spouse shouldn't think they're going to get that market consistent pension value. Rather, what the independent valuation will provide is a bargaining tool for a solicitor to use with the member solicitor, so perhaps they will get a greater share of the pension, or maybe some other assets.
It is also important to take account of benefits already in payment. Annuities or scheme pensions in payment can be valued by the provider, trustees or an actuary in line with the cash equivalent transfer value requirements. In addition to this, any state pension benefits will be given a capital value by the DWP.
Options for splitting a pension
There are a number of different options that can be utilised when looking to fairly distribute the accumulated pension assets upon dissolution of a marriage. Each has its own individual advantages and disadvantages. I will briefly look at each of these options below.
This is literally where the value of the pension is split, upon dissolution of the marriage and shared between the two parties to the marriage, leaving them each with pension benefits in their own right.
Therefore, if Mr. Jones has a Defined Contribution pension of £300,000 and Mrs. Jones has none; the pension may be split into two individual pensions giving them each a pension entitlement of £150,000.
This is a very useful option as it provides a clean break between the two parties. Each will have their own benefits to utilize to provide for their own retirement. This allows them each to go off and pursue their new lives apart, with a clear cutting of financial ties.
However, it may leave both of them with financial difficulties in retirement, as they will each have to rely on their portion of the divided pot to provide for their retirement. This is because a pension pot initially meant to provide for one household, will now have to provide for the needs of two separate households with the additional rental/ mortgage and living costs this will entail.
Pension attachment orders
An attachment order made as part of a divorce settlement requires part of the member’s pension income and/or lump sum death benefits, to be paid to their former spouse when the member retires or dies. The order will normally specify a percentage of the member’s benefits be set aside for their former spouse.
The key thing to remember here is that the benefit will still belong to the member. Theoretically this is a good idea. The member’s ex-spouse receives an income in retirement and may also be entitled to a lump sum death benefit if the member dies.
However, there are problems with this approach. Firstly, the pension income will only start to pay out when the member decides to start taking their pension benefits. Until then, the member’s ex-spouse is left in limbo. Furthermore, the member determines how the pension funds are invested and if the ex-spouse remarries or dies, the attached pension rights revert to the member. If the member dies or the ex-spouse remarries, they may lose their right to the attached pension income, which can leave the ex-spouse financially vulnerable.
From my perspective, this does not seem a very attractive option, with all the cards left in the hands of the pension member and no clear break between the two, as they continue to be bound by the attached pension rights.
However, it can be beneficial if the pension member is considerably older than their spouse. This means that the member will be able to access pension benefits long before the younger spouse would normally be able to, and upon doing so, will need to pay a portion of the income taken to their ex-spouse.
Pension offsetting is perhaps the most straightforward method of dealing with pension rights on divorce. The first step in the process is to obtain a value for the pensions. Once the pensions have been valued, the pension is exchanged for other assets in the marital estate. This means that the pension member is able to retain their pension rights by exchanging them for other marital assets.
Therefore, a pension member with a valuable Defined Benefit pension may be allowed to retain all their rights to that pension, while the member’s ex-spouse/civil partner may be given the marital home in exchange for any claims to the member’s Defined Benefit pension. The result is that the party with the smaller pension will be allocated more of the couple’s non-pension assets to balance the extra pension benefits belonging to the other.
This can be a very useful option, as it is fairly cheap to implement and provides the opportunity for a clean break between the parties involved.
However, under certain circumstances, the pension assets of one party may be so large and valuable as to render offsetting impractical. In other circumstances, it can leave the parties to the agreement in financial difficulties as they may be given the family property in lieu of a portion of some of their ex-spouse’s pension, but not have the financial means available to maintain the property.
As is always the case in these situations, the solution can be very complicated. Furthermore, it is an emotional time and the parties are often not in the best frame of mind to make reasonable and sensible decisions. It is therefore in everyone’s interest that advice is taken and experienced professionals relied upon to steer everyone involved through the myriad of options at an often-traumatic period.
By taking the right steps at this point, it is possible to minimize the impact of the divorce and put all parties in the best postion possible to forge an independent financial future.
If you have any questions, please don't hesitate to give us a call.