In this month’s article the Brand Financial Training team take a dive into the issues around pensions and divorce, a topic that can arise in the R04 and J05 exams.
Divorce can be a stressful time for anyone involved including the divorcing partners, children, other family members and legal representatives. It’s not the most comfortable of topics for CII students either. Nonetheless, it is a regular topic of discussion in R04 and J05 and students would be well advised to ensure they understand the basics.
There are three essential means of dealing with a pension entitlement on divorce:
Offsetting
This is probably the simplest of the three ways. In essence, it simply means that each party is permitted to keep their respective pension entitlements. Where one party has a larger entitlement than the other then the party with the lower pension is permitted to keep other assets of the marriage to make up the difference.
There are a number of benefits to offsetting. The main ones being that it is quick and simple. It does not require the making of a specific order outside of the divorce agreement itself and is consistent with the principle of a clean break with no ongoing contact necessary between the parties.
The main difficulty posed by offsetting can arise when the pension entitlement is very large. In such situations, there may be insufficient assets elsewhere in the marriage to fully offset the pension. It can also prove problematic where the divorcing couple are retired and the second party may have little or no pension provision of their own and no real opportunity to build one up.
Earmarking
Earmarking orders (also known as Pension Attachment Orders) have been in existence since 1996. Since December 2005, they have also been available when dissolving a civil partnership.
There are two basic types of earmarking order:
- an earmarked periodic payments order;
- an earmarked lump sum order
An earmarked periodic payments order requires the partner with the pension to make payments with a certain regularity, often monthly, from their pension in payment. This can be made on divorce either prior to, or after, vesting the pension and would usually be made against secure income-for-life plans such as a scheme pension or an annuity. An earmarked lump sum order would generally be made where the divorce takes place prior to the vesting of the pension benefits and requires payment of a portion of the member’s tax-free cash, when it becomes available.
Interestingly, where an order relates to a lump sum death benefit, the court is permitted to override the usual discretion of the trustees in determining the recipient. However, this does not cause the payment to fall into the estate for inheritance tax purposes, though as things stand, this will cease to be of relevance from 2027 onwards when pension death benefits are brought within the estate.
Earmarking orders are not commonly used these days as they are not seen as an optimal solution. Firstly, the way they operate tends to go against the principle of a clean break, given that it necessitates the parties keeping on contact. Furthermore, they present a number of practical problems for both parties:
- the ex-spouse has no control over the date of vesting or the investment of any relevant funds. The member’s decision as to when to retire is entirely at their discretion;
- in England and Wales, an earmarked periodic payments order automatically ceases in the event of the death of the member or the remarriage of the ex-spouse. This means that either of these eventualities could see the ex-spouse left without a pension;
- for tax purposes, such as income tax and the lump sum allowance, the income and the lump sum are treated as those of the member, regardless of the fact that they are not the party receiving them. This means that when the pension entitlement is significant, this treatment may not be optimal for tax purposes either.
Pension Sharing
In order to address this, the Welfare Reform and Pensions Act 1999 introduced the concept of a Pension Sharing Order. This allowed for an immediate splitting of the relevant pension entitlement between the two parties, with each immediately entitled to use their share how they saw fit. The deduction from the member’s pension rights is known as a ‘pension debit’, with the corresponding addition to the rights of the ex-spouse termed a ‘pension credit’. The latter should not be confused with pension credit the state benefit, which is designed to top-up the income of pensioners on a low income.
How a Pension Sharing Order works will depend on the nature of the scheme. With a defined contribution scheme, the ex-spouse receives a pension credit. They can then transfer the credited funds into their own pension scheme to invest and use as they see fit. Defined benefit schemes can offer two options. Firstly, a cash equivalent transfer value, which they are required to offer. This allows the ex-spouse to transfer a value actuarially equivalent to their share of the pension into a pension arrangement of their choice.
The second option is a shadow membership. Schemes are not obliged to offer this option and, indeed, many do not. This option basically sees the ex-spouse become an effective member of the scheme with an entitlement in their own name. The exception being unfunded public sector schemes, which are required to offer a shadow membership but will not generally offer a cash equivalent transfer value.
This is a brief overview of what is a very complicated topic. But it is one which has come up regularly over the years in CII exams and students would do well to ensure they can demonstrate a competent understanding of the issues.
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