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Pensions and divorce – the options

Pension rights can be one of the most valuable assets that a divorcing couple has and their treatment can be one of the most complex aspects of a divorce or dissolution settlement.

Traditionally, the value of any pension rights was simply included as a marital asset and offset against the value of other assets (such as the family home) to agree a settlement.

Offsetting is still popular, but other options are available for dealing with pension rights as part of a divorce settlement:

• Pension earmarking (introduced by the Pensions Act 1995) - which requires some of one party’s retirement and/or lump sum death benefits to be paid to the other when the holder retires or dies.
• Pension sharing (introduced by the Welfare Reform and Pensions Act 1999) – where pension rights are physically divided and some of one party’s rights are awarded to the other as their own independent pension benefits

A combination of methods can be used, but the same pension rights cannot be both shared and earmarked.

It's up to the parties and their lawyers (and, if necessary, the Court) to decide on the best method for taking pension rights into account in the divorce or dissolution settlement. None of the options are mandatory. Each case is assessed individually.

There are various factors that need to be taken into consideration and each party will need professional advice on what option is best for them. For example:

• the parties need to be aware of what the scheme's policy is on pensions and divorce and what this means for them
• both parties may need independent advice on making up any shortfall between the benefits they expected and what they will now receive
• the former spouse or civil partner of the member may need pension transfer advice

Pensions as marital assets – exclusions

Most pension rights can normally be taken into account as marital assets in a divorce or dissolution of a civil partnership, including entitlements to the earnings related element of the old State Pension (SERPS or S2P) and any protected payment under the New State Pension.

There are, however, some pension rights that are excluded - for example:

• Basic State Pension
• State Graduated Pension
• New State Pension (except for any protected payment element) or
• any survivor's pension being paid following the death of a former spouse or civil partner

In England & Wales, all pension rights belonging to either party (other than those specifically excluded, as summarised above) will normally be treated as marital assets.

But in Scotland, only those pension rights built up during the period of the marriage or civil partnership will normally be regarded as marital assets.

Pensions as marital assets – Pension Protection Fund (PPF)

Pension rights in the PPF can be shared, earmarked or offset as part of a divorce settlement. Like any other DB scheme, the PPF will provide a cash equivalent transfer value to base any settlement on.

However, where PPF rights are shared on divorce, the ex-spouse’s only option is to become a shadow member of the PPF – they can’t transfer their rights to a new pension scheme.

The shadow member's benefits:

• will be revalued from the date the sharing order takes effect until pension age by CPI up to 2.5% annually
• once in payment, any part of the credit from post 5 April 1997 service would increase by CPI up to 2.5% annually and
• the pension age will normally mirror the original member's NRD in the scheme. A shadow member may be eligible for early retirement from age 55.

Valuing pension rights on divorce

The law sets out how pension rights should be valued for the purposes of divorce or dissolution of a civil partnership.

• Pre-retirement rights, or income drawdown funds, under registered pension schemes will normally be valued based on their cash equivalent transfer value
• Annuities or scheme pensions in payment should be valued by the provider, trustees or an actuary in line with the cash equivalent transfer value requirements
• Rights under the earnings related element of the State Pension scheme, and any protected payment under the New State Pension, will be given a capital value by the DWP

In Scotland, the transfer value is pro-rated to reflect that it's only the assets attributable to the period of the marriage or civil partnership which are taken into account on divorce or dissolution. In England and Wales, all of the assets have to be considered, not just those acquired during the marriage or civil partnership.

Pension sharing

Pension sharing was introduced by the Welfare Reform and Pensions Act 1999, to give a ‘clean break’ option for dealing with pension rights on divorce or dissolution of marriage, where the petition for divorce or dissolution was served after 30 November 2000.

It's not available for cohabitees or for couples who are seeking a legal separation rather than a divorce or dissolution.

Under pension sharing, pension rights are divided at the time of the divorce or dissolution. When a pension sharing order is made, part of the member's pension rights are awarded to the former spouse or civil partner of the member as a pension credit. This provides the former spouse or civil partner with pension benefits in their own right, independent of the member's benefits. A corresponding pension debit is recorded against the member's benefits.

If the member has more than one pension scheme, it's not necessary for benefits under all the schemes to be shared. A sharing order can be made against just one, or some, of the schemes to provide for the former spouse or civil partner.

If a sharing order is made against a scheme that contains both contracted-out and excess rights, the former spouse or civil partner must be given a proportionate share of each type of benefit. For example, if a sharing order specifies a 70% benefit share, the pension credit must be made up of 70% of the contracted-out element and 70% of the excess element.

If the divorce occurs in Scotland, a share of pension funds can be achieved either through a pension sharing order or a 'qualifying agreement'. This latter method is a written agreement between the parties which:

• has a schedule of information on the parties and the pension
• shows that the scheme has been informed in advance and
• is registered in the Books of Council and Session

Pension sharing – advantages and disadvantages

Pension sharing has a number of perceived advantages and disadvantages.

The main perceived advantages of pension sharing on divorce are:

• It provides a clean break between the parties
• Each party has independent pension benefits in their own right, under their control
• The member whose pension benefits are subject to a sharing order will be able to keep more of the non-pension assets
• Neither party's rights are affected by the other's subsequent death or remarriage

The main perceived disadvantages of pension sharing on divorce are:

• The loss of death benefits for the former spouse or civil partner of the member
• The member may not be able to replace the lost pension fund
• The member can, in some circumstances, lose primary or individual protection as a result of pension sharing
• In return for the pension share, the former spouse or civil partner of the member will receive less of the couple's non-pension assets. This could leave them with financial difficulties if they're below pension age and, therefore, unable to access the pension credit rights

Pension earmarking

A pension earmarking order (or pension attachment order) made as part of a divorce settlement requires part of the member's retirement benefits, and/or lump sum death benefits, to be paid to their former spouse or civil partner when the member retires or dies. In Scotland, only lump sums can be earmarked - it's not possible to earmark pensions.

• It's available in relation to any divorce or dissolution petitions served in England & Wales from 1 July 1996 (or 19 August 1996 in Scotland) where the earmarked payments start after 5 April 1997
• Any new orders will earmark a percentage of the member's benefit for the former spouse or civil partner, but orders made before December 2000 could earmark a fixed monetary amount
• Although benefits under most kinds of pension scheme can be earmarked, no State Pensions can be made subject to an earmarking order
• Dependants' pensions cannot be earmarked

The earmarked benefits continue to belong to the member. This means that:

• the member can normally control when any pension payments start
• any pension payments (including the earmarked portion) will be taxed at the member's income tax rate
• pension payments to the former spouse or civil partner will stop on the member's death
• the full pension will revert to the member on the death of the former spouse or civil partner
• pension payments to the former spouse or civil partner will stop if they remarry

Pension earmarking - transfers

A member can transfer their pension benefits after they become subject to an earmarking order, but the trustees of the transferring scheme must tell the trustees of the receiving scheme that an earmarking order is in place and it will then apply to the new scheme.

In practice, some pension schemes will refuse to accept transfers involving earmarked benefits.

If earmarked pension rights are transferred, the former spouse or civil partner of the member must be told and given contact details for the new scheme.

Pension earmarking – advantages and disadvantages

The main perceived advantages of pension earmarking on divorce are:

• No money changes hands at the point of divorce or dissolution
• From the member's perspective, the earmarked benefits will revert to them if their former spouse or civil partner dies or remarries
• From the former spouse or civil partner's perspective, lump sum death benefits can be earmarked to protect them in the event of the member's premature death

The main perceived disadvantages of pension earmarking on divorce are:

• There's no clean break between the parties
• The member keeps control of the investment mix and over the timing of the former spouse or civil partner's pension
• The tax earmarked pension is subject to tax at the member's marginal rate. This could work either way of course, but often this can result in more tax than if the benefits had been taxed at the former spouse or civil partner's rate
• The former spouse or civil partner loses their earmarked pension if they remarry or the member dies. They may be able to maintain some or all of their entitlement to any earmarked lump sum, subject to the terms of the order allowing it

Pension offsetting

The basic principle of pension offsetting as part of a divorce settlement is very simple:

• The couple's pension benefits are given cash values. These are normally based around the cash equivalent transfer value, but might also take account of lost death benefits
• These values are then taken into account in the marital balance sheet when each party's assets and liabilities are weighed up
• Each party keeps their own pension benefits, with other marital assets (such as the family home) being traded off against them to balance the divorce or dissolution settlement
• 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

As pensions are subject to income tax when they become payable, the cash value placed on the pension will generally be reduced to take account of the tax. For example, if the member is a higher rate taxpayer, the cash value of the pension rights based on the transfer value may be reduced by say 30% (that is, 40% of the 75% pension left after the tax free cash).

Of course, offsetting is only viable if the couple have enough non-pension assets to offset against the value of the pension rights.

Pension offsetting – advantages and disadvantages

Pension offsetting is perhaps the most straightforward method of dealing with pension rights on divorce. However, in practice, there can be difficulties in using this method.

The main perceived advantages of pension offsetting on divorce are:

• It provides a clean break between the parties
• It's simple and cheap to implement

The main perceived disadvantages of pension offsetting on divorce are:

• The member has to give up tangible assets, such as their home or car, in order to keep their pension. This could leave them with real financial difficulties
• Similarly, the former spouse or civil partner of the member could, for example, be given the house but have no income to run it
• The value of one party's pension rights might heavily outweigh the value of the other marital assets, making offsetting impractical