What are the different ways of dealing with pension benefits?

What are the different ways of dealing with pension benefits?

There are three ways of dealing with pension benefits upon divorce.

1. Offsetting

2. Pension Attachment/Earmarking

3. Pension Sharing

We will look at each one in turn.

Offsetting

This is the simplest way to deal with the pension benefits. The total value of the pension benefits are offset against other assets – for example a greater share of the family home is given to the ex-spouse in return for the member keeping all of his or her pension.

Advantages:

  • Settled out of Court
  • Achieves a clean break

Disadvantages

  • How is a fair value achieved?
  • The value of pension may be higher than other assets
  • Pension values may fluctuate more than house prices

Simple scenario

Jack and Jill are in the process of getting divorced.

  • Jack is a member of a final salary pension scheme which promises to pay a pension at retirement. The value of this pension is £500,000.
  • Jill has no pension rights but the matrimonial home is also valued at £500,000.

Jack gets to keep his pension and Jill gets ownership of the family home.

Not so simple scenario

Mr & Mrs Jones are getting divorced after 22 years of marriage.

  • Mr Jones retired at age 65 and receives a pension that includes a spouse’s pension payable on his death. He also has some savings.
  • Mrs Jones is age 45 and still working and is a member of a good pension scheme that includes a spouse’s pension payable on her death.

The capital value of Mr Jones‘s pension rights exceeds that of Mrs Jones, a significant part relates to a widow’s pension paid on his death. Once divorced Mrs Jones would not benefit from this.

It was decided that "offsetting” was the most appropriate solution. Mr Jones also had to pay some money to Mrs Jones from his savings.

Why do you think age could be an important factor in this scenario?

At 45 Mrs Jones is still young enough to continue working for a higher pension at retirement, but:

1. Prior to the divorce Mrs Jones would have been entitled to a widow’s pension when her husband died. As she is 20 years younger there is a strong possibility she would have received this pension and for a long period after his death.

2. The pension scheme to which Mrs Jones belongs also had a widower’s pension if she dies first but as there is a twenty year age difference, Mr Jones would be unlikely to receive it – due to mortality she would be expected to outlive him.

This scenario shows that the loss of potential future benefits should also be taken into account.

Pension Attachment/Earmarking

If this option is selected, part of the member’s benefits are set aside for the ex-spouse/civil partner as directed by the Court. The amount is specified at the time of divorce/dissolution and an Attachment Order is made against the member’s benefits. It takes effect when the member’s benefits come into payment.

Both pensions and lump sums (including death lump sums) can be earmarked except in Scotland, where orders can only be made against lump sums.

A copy of the application to the Court is sent to the scheme administrator outlining the order to be sought (Form P2). The trustees may request further information about it, object to it and be represented at any hearing.

If the application is an agreed Order, the trustees have 21 days to object. Once an Order has been made the ex-spouse/civil partner must serve it on the pension scheme.

Earmarked Pensions

Some aspects to consider regarding earmarked pensions

  • There is no clean break for the member and no guarantee of benefits for the ex-spouse/civil partner.
  • The ex-spouse/civil partner only receives the benefits when the member does.
  • If the member dies, the earmarking order falls away.
  • If the ex-spouse/civil partner remarries or the ex-civil partner forms a new civil partnership, the earmarking order ceases, although generally lump sum earmarking orders don’t fall away on remarriage or on forming a new civil partnership.
  • The ex-spouse/civil partner will need to know how the income will affect tax payments.
  • The pension to the ex-spouse/civil partner is taxed as though paid to the member and the ex-spouse/civil partner has no income tax liability at all.
  • Any earmarked lump sum will still be tax free.

Pension Sharing

Introduction

The Pension Sharing option only applies to divorce proceedings from 1 December 2000 only.

The member may not have a choice as the Court can order pension sharing to take place.

The Order is sent to the scheme administrator who must implement it as directed.

It separates the member’s pension entitlement so there is a clean break; it offers greater flexibility than earmarking/offsetting.

It applies to all pension assets belonging to the couple except for Scotland where it only applies to pension assets built up during the period of marriage/civil partnership.

Some Basic Rules

To enable a Pension Sharing Order (PSO) to be implemented, the member must provide the scheme administrator with the decree absolute.

A PSO cannot be made where:

  • There is already a PSO on the pension arrangement in respect of the same marriage;
    or
  • If an earmarking/attachment order exists in respect of any marriage

It does not apply where a member has less than 3 months’ pensionable service, unless they have preserved pension rights.

You should note that a UK pension provider cannot comply with an order for pension sharing that has been made against it by an overseas court. A UK court order would need to be granted before the scheme could act on it. Without a UK court order the scheme would be accused of assignment of benefits which is prohibited under the Pensions Act 1995 and would result in unauthorised payments being made.

Pension Debit and Pension Credit

The PSO states the percentage of the member’s benefits to be given to the ex-spouse/civil partner. It can be anything between 1% and 100%.

The member’s pension is reduced accordingly. This is known as a "Pension Debit”.

If a member has benefits in a DC scheme, the amount is simply deducted from the value of the member’s pension pot. The ex-spouse/civil partner will then transfer their benefits, either internally (so that the benefits are held under their name in the same scheme as the member) or externally, to a different pension scheme. The ways in which those benefits can be paid out to them on retirement will depend on the scheme into which they transferred them.

However, if the benefits are in a DB scheme, it is more complicated and the scheme administrator has to keep track of the pension debit. The PSO percentage is applied to the member’s pension rights and that amount is revalued in accordance with statutory revaluation orders, the amount is then deducted from the member’s benefits at retirement.

See below an example of how this works in practice.

Now

  • Active member, age 50, earns £30,000 p.a., NRA is 60
  • Accrued pension = 1/60 x 20 x £30,000 = £10,000 p.a.
  • PSO states 40%
  • Pension debit = £10,000 x 40% = £4,000 p.a.

NRA

  • Accrued pension = 1/60 x 30 x £60,000 = £30,000 p.a.
  • Pension debit of £4,000 p.a. is revalued in accordance with the scheme rules and increases to £6,000 p.a.
  • Pension to the member after applying the debit = £30,000 - £6,000 = £24,000 p.a.

With either scheme, the member will need to consider how they can rebuild the funds they have lost.

The ex-spouse/civil partner receives a corresponding "Pension Credit”. This benefit is completely independent of the member’s benefits and will be used either as an internal or external transfer. The pension credit amount counts against their LTA unless it arose from benefits that came into payment after 6 April 2006, as they will already have been tested against the LTA.

When the ex-spouse/civil partner retires, they will be able to take a PCLS from the benefits provided in respect of the pension credit, unless the member’s benefits were already in payment when the pension share occurred.External Transfer

The scheme rules will state if an eternal transfer is allowed and in many cases they insist on it.

An external transfer simply means that the ex-spouse/civil partner must transfer the pension credit to a suitable qualifying arrangement.

If the scheme is in deficit the pension credit may be reduced by the percentage by which the scheme is underfunded at the valuation date. In such cases, the requirement for an external transfer cannot be imposed. The ex-spouse/civil partner can choose to delay an external transfer until the scheme becomes fully funded again.If the ex-spouse/civil partner does not respond to requests for information about the arrangement to which the pension credit should be paid, the trustees can propose an alternative arrangement on his or her behalf.

Internal Transfer

With an internal transfer, the pension credit remains in the scheme and the ex-spouse/civil partner is treated as a deferred scheme member.

The ex-spouse/civil partner becomes entitled to all other benefits of the scheme, although they do not have to mirror those of the scheme. For example, the ex-spouse/civil partner can make further contributions (subject to scheme rules), retire at scheme Normal Retirement Age and take a PCLS at retirement.

If the member’s scheme is underfunded then the ex-spouse/civil partner can still choose an external transfer with a reduced pension credit. 

Protected Benefits

Pension sharing may have an impact on members who have protected benefits.Primary Protection – Pension Debit

If the member has this, HMRC must be notified and the protection reduced accordingly. The reduced personal LTA will apply to all future Benefit Crystallisation Events (BCE) after the benefits have been reduced by the pension debit.If the pension debit brings the value of the member’s benefits to below £1.5million, primary protection will be lost. The member will revert to the standard lifetime allowance.

Primary Protection – Pension Credit

Primary Protection is not affected if a member receives a pension credit. This may lead to the member’s benefits exceeding their personal LTA on retirement.

Enhanced Protection – Pension Debit

If the member is in a DB scheme they may be able to rebuild some or all of the lost pension rights but need to take care that "relevant benefit accrual” does not occur as that will result in enhanced protection being lost.

For members of DC schemes, if any contributions are made by a member to restore pension rights, this will result in the loss of enhanced protection."Relevant benefit accrual”

The relevant benefit accrual test for a defined benefits arrangement is done when benefits come into payment or are transferred. Contributions may continue after 5 April 2006 without causing loss of enhanced protection. Benefits may continue to accrue after 5 April 2006 (for example rebuilding lost pension rights following a pension debit as outlined in this module).

But the extent to which further benefits may accrue is set in legislation. For an explanation of the method to test relevant benefit accrual please see link to HMRC’s Pensions Tax Manual below.

https://www.gov.uk/hmrc-internal-manuals/pensions-tax-manual/ptm092400

NB: You will not be expected to answer questions on how to test whether there has been relevant benefit accrual but you should be aware that rebuilding lost pension rights may cause enhanced protection to be lost.

Enhanced Protection – Pension Credit

Where the member is the ex-spouse/civil partner receiving the pension credit and they have enhanced protection on the scheme, if they set up a new arrangement to accept the pension credit, they will lose their enhanced protection. 

They should ensure that the credit is transferred into the arrangement where they have the enhanced protection. If the member is in a DB scheme the pension credit could later result in relevant benefit accrual having occurred by the time they retire or transfer, so enhanced protection could then be lost.

Fixed Protection – Pension Debit

This protection will be retained but members may wish to revoke it if they want to make further contributions or accrue additional benefits to make up the pension debit shortfall.

Fixed Protection – Pension Credit

Where the member is the ex-spouse/civil partner receiving the pension credit and they have fixed protection, they can retain it if the pension credit is transferred to an existing registered money purchase arrangement.

Pension Sharing Problems

Some of the common problems are shown below:

  • There could be delays in collating information, particularly where the member has several pension arrangements.
  • If the member has several schemes, which one should have the pension debit? The member needs to consider carefully, as we have seen earlier particularly where there are protected benefits involved.
  • Payment of charges – these can be expensive (around £1,000). On the PLSA website there are example charges. Delays can occur if one party refuses to pay the charges, even though they are required to do so by the Court Order. In general charges can be recovered by asking for direct payment by the member and/or ex-spouse/civil partner, or by deduction from the benefits. However, the latter method can be used only if the charges are not required to be paid before the implementation of the pension share.
  • Sometimes the Court forgets to send the scheme administrator the PSO, or it’s not properly stamped.
  • If an external transfer is taking place to an overseas scheme, additional checks may be required.
  • If the member is already in receipt of their pension then there could be some overpayments while the PSO is being implemented. These overpayments will have to be taken into account and could affect income tax. It is important that the scheme makes it very clear to the member, if an overpayment is expected, that it will be reclaimed once the PSO has been implemented – this is a common area for complaints to arise.

A divorcing couple agree to equal pension benefits and a PSO is received for 50%.

The CETV from the DB scheme is £200,000 so £100,000 is transferred into a Personal Pension Plan for the ex-spouse.

On retirement a few years later, it transpires that the share of the DB scheme benefits is much greater than the share in the Personal Pension Plan.

What do you think the problem was in this case?

The couple agreed to equal benefits but what did they actually mean?

  • A simple split of the transfer value amount 50/50 does not provide for "equal benefits”.
  • It was found that to equalise benefits, the amount transferred to the PPP should have been higher to account for the fact that the retained share in the DB scheme was subsidised by the employer, whereas the amount transferred to the PPP was not.
  • In this case, a further payment had to be made to cover the shortfall of "equal benefits” including loss of growth between the transfer date and retirement date.

It was suggested that pension sharing on an income basis could have been a fairer approach for both parties.