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Pension Sharing on Divorce

Not the most enjoyable area to write an article on, but one which will have relevance to some Liberty SIPP customers.

When a couple get divorced (the “member“ being the person with a pension fund, and the “ex-spouse” being the party with a potential claim on the pension fund), there is no definitive way of dividing the assets.  The pension may or may not be taken into account, and if it is, there are several ways of treating it: offsetting, earmarking and pension sharing.  The same applies to the dissolution of civil partnerships.

Offsetting

Offsetting came about as a result of the Matrimonial Causes Act 1973, making it possible for the value of the pension funds to be taken into account in divorce proceedings by offsetting it against the value of the couple’s other assets.

Offsetting is the easiest to understand, and therefore in many cases the preferred option.  To calculate each party’s share, the pension fund is given a lump sum value in today’s terms, and considered along with the other assets of the marriage.  Using this method the ex-spouse would receive a higher proportion of the couple’s assets to compensate for the loss of their share of the pension fund. 

It is important to note that the assets are not always divided 50/50, and in cases where both parties have a pension or if the marriage is of a short duration, pension funds may not be taken into account at all.

The advantage of offset is that it is done at the time of the divorce and allows the couple a clean break.  However, if the member is allocated the pension fund, they have to wait until retirement to receive the benefit, whereas for the ex-spouse the benefit is immediate, although sometimes there are insufficient assets to cover the amount of pension to be offset.

Earmarking

Earmarking was introduced by the Pensions Act 1995 and came about due to failings of the offsetting method, especially where there were insufficient assets to cover the amount of pension funds to be offset.  Earmarking allows the ex-spouse to have benefits earmarked in the member’s pension scheme so that they receive an income on retirement or on death of the member.  Following the Welfare Reform and Pensions Act 1999, earmarking orders must be expressed as a percentage of the pension income and/or tax-free cash.

The disadvantage of earmarking is that benefits to the ex-spouse do not become payable until the member takes benefits, which could be as late as age 75.  This can, however, work to the ex-spouse’s advantage if the member takes early retirement. 

Problems can arise when benefits are transferred to another scheme, especially if only part of the benefit is transferred, as the earmarking order does not transfer to the new scheme and the ex-spouse can only claim against the original scheme.  It is also easy to lose track of the earmarking order should there be a change of address.  There are also drawbacks in the event of death or remarriage.  Earmarking should only really be considered if there are insufficient funds to be offset.

Pension Sharing

Pension Sharing is available only where petition for divorce was filed after 1 December 2000, and achieves a clean break between the divorced couple with regards to pensions.  If divorce proceedings commenced prior to this date, offsetting and earmarking are the only options. 

Pension sharing gives the member’s benefit entitlement a cash transfer value at the time of divorce, and splits the member’s pension rights, with a proportion being transferred to the ex-spouse so that he or she can receive benefits in his or her own name.  The benefits received by the ex-spouse are called pension credits, and those taken from the member are pension debits.  Pension credits can be expressed as a percentage of the fund for money purchase schemes, or a number of years for a final salary scheme.  Only the benefit rights that have built up prior to divorce can be shared, however in Scotland it might only be the pension benefits that have built up during the period of the marriage.  Each party is then taxed just on the benefits they actually receive, and death or remarriage of either party has no effect on the pension sharing order.

The treatment of the share for the ex-spouse varies depending on the type of scheme with regard to whether a transfer value or membership of the scheme is offered. 

If a pension sharing order took place before ‘A’ Day, the ex-spouse can apply for an increase in the lifetime allowance to accommodate the pension credit.  However if Primary Protection has been obtained, the credit will already have been taken into account.  Conversely a pension debit will reduce the Primary Protection factor, and if the fund reduces to less than £1.5 million, the protection will disappear.  If the pension sharing order occurred on or after ‘A’ Day, the pension credit will count towards the ex-spouse’s lifetime allowance except where the pension credit comes from a member’s pension when they are already in drawdown.

If a pension sharing order took place before 5 April 2006, the pension debit is sometimes considered when calculating the HMRC’s maximum benefits.  If a member has Primary protection he or she would have to be given a new personal lifetime allowance, taking into account the new lower value.
The ex-spouse will not receive any physical assets as they would under offset, but with this method the ex-spouse has control over when they can take the benefits, unlike with earmarking.