Divorce - the draft bill on splitting pensions

United Kingdom
Nicholas Donnithorne looks at a case of earmarking in practice and the draft bill on splitting pensions

How best to deal with pensions on divorce was one of those issues which spent many years on the "too difficult" pile of Ministers. However, they were forced to confront the issue during the debate on the Pensions Act 1995 and since then much effort has been put into getting the details right. The Pensions Act introduced an intermediate stage, pensions earmarking. Now we have a Bill, unusually published in draft form, to achieve the probably more satisfactory solution of pension splitting.

Earmarking - TvT

Many schemes have now seen at least a few earmarking orders, but most of these have been as a result of consent orders - where the divorcing couple have, however reluctantly, come to an agreement.

It is only with the case of TvT earlier this year that the Courts' thinking on contested hearings can start to be judged. It also illustrates some of the problems with earmarking.

Facts

Mr and Mrs T had been married for fourteen and a half years before separating. They had no children. Mrs T had worked for the first half of the marriage but had given up her job some seven years before the separation. Mr T was an executive director of the derivatives and futures department of a bank.

Mrs T's claim

Mrs T asked for an order containing three elements:


  • the lump sum of four times Mr T's salary which would arise if he died in service;

  • a lump sum if he survived to retirement; and

  • a periodical pension at a rate of almost £39,000 on his retirement.

Valuation of pension rights

Although the relevant legislation states that pension benefits are to be valued on the basis of the member's cash equivalent, the one thing on which both sides' actuaries agreed was that this was not appropriate in this case. Uncertainties over the operation of the Pensions Act and the Minimum Funding Requirement meant that the trustees could not give a transfer value. The judge accepted that this would not have helped in any event in this case.

The Court accepted the more traditional valuation method of considering the prospective pension as a stream of income. The actuaries had to establish what benefits the couple would have been entitled to, discount this to give a current value and then apply discounts to take into account the possibility that either or both of them would die (or in Mrs T's case re-marry) before receiving the benefits.

The Court agreed that the benefits which should be valued included the death in service lump sum, the widow's pension and any balance of the five year pension guarantee. More interestingly, the Court also agreed to value and take into consideration 50% of Mr T's pension from the date of his retirement, rather than merely from when the widow's pension commenced; this was counted as part of the pension benefits lost by Mrs T on the divorce.

Pension rights

Mrs T's barrister argued that the earmarking provisions of the Pensions Act 1995 required the Court to treat pension rights separately from other assets and to compensate for their loss even where the other assets were sufficient to provide the normal benchmark for provision on divorce - a former spouse's reasonable needs. The judge rejected this view "unhesitatingly". Although the Pensions Act requires the Court to take pension rights into account when considering the assets of the marriage, the powers involved merely expand the options available to deal with the assets of the marriage. On this basis the Court can quite properly consider that the other arrangements it has made are sufficient.

The nature of an earmarking order was also considered. The judge confirmed that it is like any other maintenance order in that it ends on remarriage. It is also subject to either party's right to seek a variation of the order at any time during the paying spouse's lifetime.

At the time of the divorce, Mr T was only 46 years old. The judge took the view that dealing in detail with circumstances which would not occur until some 14 years later was not realistic. Even then Mr T could delay his actual retirement and so frustrate any earmarking order for up to 15 more years. It would be more appropriate to make any such order much nearer to Mr T's retirement date. At the time the Court could also consider how, if at all, the start of earmarked pension payments should reduce any periodical payment order still in existence.

The death in service lump sum was viewed differently. The judge accepted that it provided a form of insurance for Mrs T against Mr T's early death and the consequent loss of her future pension. He ordered the trustees to make a payment of ten times the annual level of maintenance at the time of death (or the whole of the lump sum, if smaller) out of the death in service lump sum.

Comment

This might have been a more appropriate case for the pension splitting powers yet to come. The judge foresaw "a number of potential pitfalls, disadvantages, complications and distractions" if he were to direct an order for deferred periodical payments. In this case there was no evidence that normal maintenance orders would be flouted. The couple were a long way from retirement ages which introduced a lot of uncertainty to any order the court might make. Perhaps of greatest importance was the fact that the assets of the marriage and Mr T's salary level meant that the judge had freedom to broker a "fair" deal without breaking up the pension rights.

Pensions earmarking will remain a valuable option for those who are close to retirement. However, this case shows that Courts will, quite sensibly, be loath to use earmarking in straightforward cases where there is no obvious advantage in the complication it brings. Common sense decisions like this will save time and effort for pension scheme administrators and, as costs would be borne by reduction of benefits, maintain the value of benefits provided to members.

Pensions splitting

The Government has now published a consultation paper and draft Bill for the other method of dealing with pensions on divorce - pension splitting, or as it is now described, "pension sharing".

Under the Bill, pension rights will be treated like any other asset so that the whole or a proportion of their value can be transferred from one spouse to the other as part of the financial horse trading on divorce or annulment. Pension sharing will simply be one of many options facing divorcing couples. It will still be possible to offset pension rights against other matrimonial assets or to use the earmarking orders under the Pensions Act 1995.

What pension rights will be covered?

The legislation is very wide-ranging; it covers occupational pension schemes, personal pension schemes, retirement annuity contracts and other annuities and pension policies. Even SERPS is covered. The basic state flat-rate pension is about the only pension arrangement not potentially within the scope of a pension sharing order.

How will it work?

Pension sharing is far more consistent with the "clean break principle" which the Courts have striven towards. The problem with earmarking is that it is a parasitic right; the ex-spouse's pension rights depend on when the member begins to draw a pension (which, as noted in TvT, the member can postpone for many years) and, worst of all, the pension dies with the member.

When will it apply?

Pension sharing will only apply in relation to proceedings for divorce or annulment which begin after the new arrangements come into force.

A member's pension rights will become subject to a "debit" and the former spouse will become entitled to a pension "credit" equal to the amount of the debit. The amount of the debit will (in England and Wales) be a percentage of the cash equivalent of the member's pension rights accrued up to the day immediately before the day on which the court order takes effect, and will be specified in the pension sharing order.

Pension sharing can apply to a deferred, active or pensioner member. A survivor's or dependant's pension for which the member may have qualified (e.g. following the death of a spouse from a previous marriage) cannot be subject to pension sharing.

For members of a money purchase scheme, the debit will normally take the form of a once and for all reduction of a percentage of the money in the member's "pot", so if the order provides that the member's pension rights are subject to a debit of 30% of the cash equivalent, that amount will be taken from the pot and be available for the former spouse.

As usual, the position is more complicated for final salary schemes. The following example is provided in the notes to the Bill:

Deferred pension at date of divorce:
    20/60ths x £30,000 = £10,000

Cash equivalent for pension sharing calculated by actuary:
       £100,000

Pension debit ordered by Court (40% of cash equivalent):
       £40,000


At retirement the member's benefit will be as follows:


  • the member retires at age 60 after 30 years service with a salary of £48,000

  • full pension entitlement (ignoring debit) 30/60ths x £48,000 = £24,000

  • the actuary calculates that the deferred pension of £4,000 (i.e. 40% of the deferred pension of £10,000 at date of order) is equivalent to a pension of £6,000 a year at retirement. This is known as the "negative deferred pension"

  • the member's actual pension will be £24,000 minus £6,000 = £18,000.

On the winding up of an occupational pension scheme the normal statutory priorities will apply so that if a spouse with a pension credit is actually drawing a pension from the scheme they will get a higher priority than one who has not begun drawing a pension.

Administration

Inevitably, pension sharing will give rise to additional administration. Pension schemes will be able to recover reasonable administrative costs from the divorcing couple e.g. valuation of rights and the costs of discharging the liability for the pension credit and reduction of the member's benefit. These can be paid in cash or as a pension deduction. Pension schemes will not be obliged to impose such charges and the Government does not intend to impose charges in connection with SERPS rights. However, the general cost to a scheme of keeping a new class of deferred pensioners will not be recoverable.

Transfers

Provided the pension scheme is funded, the ex-spouse will be permitted to transfer his or her newly acquired rights to another scheme. This may be fine where the ex-spouse becomes a member of another occupational scheme willing to accept the transfer, but the prospect of a small transfer payment to a personal pension may not prove an attractive proposition in relation to the charges likely to be levied. The pension scheme will, however, be able to buy-out ex-spouses' benefits if it wants to. Schemes will have to formulate a policy on whether or not to retain such benefits and incorporate this into scheme rules.

Penalties

OPRA will be given power to impose penalties where schemes have not complied with pension sharing orders within four months of receiving the order and accompanying details.

Clearly pension sharing is a good idea but the implementation of yet another set of complicated administrative procedures and yet more jargon will add to the administrator's and ultimately the trustees' burden.