Providing pension provision on divorce

Pension rights have had to be considered in divorce settlements in Scotland for some considerable time. Until now there was, however, only one possible approach, as the actual pension rights could not be transferred in any way or form to the spouse of the pension scheme member. This article considers the forthcoming changes. For simplicity, I will refer throughout to the husband as the pension scheme member.

The Value of Pension Rights

It is worth stressing just how important pensions are now in the UK economy. There are over 22 million people with pensions that will need to be taken into account on divorce. Private sector schemes alone have a capital value of more than £1,000 billion, which is over £50,000 for each family in the UK. For many families, therefore, they will be the biggest single asset, often exceeding in value the equity in the family home.

Pension rights are valuable assets, which are usually built up over the course of a marriage. Conceptually they are like building society accounts or endowment policies. The snag with pension rights is that they do not have a market value in the same way as these types of assets, or as would a house or car. Although pension rights are generally described by reference to the amount of the annual pension and other benefits, they do, however, still have a capital value. This is actuarially determined as the capital amount required to replace the pension rights.

Family lawyers are well used to scheduling the values of the assets of a marriage and determining the way in which they are to be divided between the couple. These schedules of assets must include the capital value of the pension rights. This is the only way of dealing fairly with, on the one hand, pension rights, and, on the other hand, assets such as houses, cars and bank accounts.

This has been the approach adopted to date since the introduction of the Family Law (Scotland) Act 1985, both before and after the Pensions Act 1995. The pension scheme member kept his pension rights (perforce), and the value of these was offset against the other assets. Since 1996 it has also been possible to use “earmarking” orders if there were insufficient assets in the marriage to allow a fair division to be effected immediately.

A New Principle

The Welfare Reform and Pensions Act 1999 (WRPA 99) introduces an entirely new principle into pension fund law. Previously (for all practical purposes) there had been no way of taking benefits away from a pension scheme member. This is precisely what the WRPA 99 introduces. It enables the value of the pension scheme member’s pension rights to be shared (or split as it was originally known) between the pension scheme member and his ex-wife.

The importance of this is that the ex-wife’s future pension rights can be entirely separated from the pension scheme member’s pension rights. The essence of pension sharing is that the pension scheme member’s rights are diminished and the ex-wife of the pension scheme member has a pension right created for her independently which she can deal with as is appropriate in her own circumstances.

The only drawback is that the benefit does have to be in the form of a pension, with the usual restrictions. It cannot be available as immediate cash. However, in this age of inadequate state pensions, pension rights are highly attractive assets.

It is important to remember that this is only an option; the current practice of offsetting the capital value against the other assets remains available. This new option will be available for all divorce actions commenced on or after 1 December 2000. It can only be actioned, however, at the time of divorce. While a separation agreement may determine that sharing of the pension rights will take place, the pension scheme cannot accept an instruction until the divorce occurs. The instruction can be in the form of a court order or a minute of agreement between the two parties. It should be noted that this latter approach is not available for divorces in England and Wales, and many English based pension schemes may not realise that it is a valid method in the Scottish context.

What will be shared?

It is the capital value of the pension rights that will be shared. That is as it should be. It is a stated policy intention of the legislation that a pension share should be cost neutral to the pension scheme, and thus the total capital value after sharing must be no greater than it was before. If the couple are about the same age, this will mean that the annual pension set up for the ex-wife will be less than her ex-husband’s annual pension because her expectation of life is longer than his. In a more extreme case, it would clearly be quite unfair to share a pension payable to an old man with a young wife on the basis of the same amounts per annum to each.

The regulations are clear that the capital value that is used by the pension scheme must be the Cash Equivalent Transfer Value (CETV). Even pensions in payment, which do not have CETVs at present, will use the CETV; schemes will be required to provide them from December 2000.

The regulations are equally clear that the split does not have to be 50/50; anything between 100/0 and 0/100 is acceptable. This may be used to achieve a satisfactory division of all the assets. In addition, there are a significant number of circumstances where the CETV is not an accurate assessment of the value of a pension. The differences between a reasonable and fair value and the CETV can be enormous. For example, for an active member of the Armed Forces Pension Scheme the real value can be three times the CETV. It is essential to consider this before determining the amount of the pension share.

It is also important to realise the effect of timing. Where the pension rights are offset against other assets, this is done as at the Relevant Date. This is usually the date of separation, and is frequently some years prior to the date of divorce. The same approach is to be applied to pension sharing, but this will create significant practical problems.

The new pension rights for the ex-wife will be purchased at some date in the few months after the divorce. If only the value at the date of separation is considered, this will probably result in the husband losing less pension, and the ex-wife getting less pension than was intended. The differences can be very large. It will be necessary, therefore, when determining the amount of the share to take account also of the current value of the appropriate portion of the pension rights. Note that this is not an issue in England and Wales where the concept of the Relevant Date does not exist, and many English based pension schemes may not be aware of the Scottish situation.

Pension sharing in unfunded schemes

Many public sector pension schemes, such as the Principal Civil Service Scheme, are “unfunded”; that is to say there is no fund of investments backing the pension rights. The pension scheme member’s benefits will be paid out of future taxation. In these schemes, pension sharing must be implemented by giving the ex-wife membership of the scheme in her own right. The WRPA 99 therefore introduces an entirely new category of pension scheme member. This category is similar in many ways to that of deferred pensioners (that is pensions for ex-employees), but their detailed rights are not identical.

Note that the ex-wife does not have access in the form of cash to the value of the shared pension rights. In these unfunded schemes it may not be possible to take the CETV of the pension rights and transfer it to another scheme.

Pension sharing in funded schemes as it affects the ex-wife

Most private schemes are “funded”, that is to say there is a fund of investments backing the pension rights. In these schemes there may be up to four possibilities:

• The internal option, under which the ex-wife becomes a deferred member of the pension scheme;
• The external option, using the value of the shared pension to buy a Personal Pension for the ex-wife with a provider chosen by the ex-wife;
• The external option, transferring the value of the shared pension to another approved pension scheme;
• If the ex-wife does not make a positive choice, the pension scheme can establish a pension with the scheme’s “default provider”.

It must be remembered that the internal option will not always be available. The pension scheme normally has the right to decide whether or not it is prepared to allow this option, as there is extra expense for the pension scheme in catering from an additional category of member. The exception to this is that the scheme may be forced to offer the internal option if it is “underfunded” (ie there are not enough investments in the fund to meet the requirements of the Regulator). This is in order to protect the ex-wife since, when a pension scheme is underfunded, it has the right to reduce its CETV. In these circumstances it may be better for the ex-wife to become a member of the pension scheme, because in the long run the pension scheme is likely to pay the full benefits.

The second option is that the ex-wife can simply use the value of the shared pension to buy a Personal Pension from a pension provider of her own choice. The amount will be the agreed share of the CETV, less any part of the charges that the ex-wife has agreed to pay. This action will discharge the scheme from its obligations as regards the shared pension.

The third option is that, if the ex-wife is an active member of an approved occupational pension scheme, a transfer may be made to that scheme, providing the scheme is willing to accept the transfer.

The fourth possibility is that of the default provider. The scheme will simply make a payment to an external provider of its own choice to purchase benefits in the name of the ex-wife. This will only happen where the ex-wife gives no instructions, and the pension scheme will thus have a way to discharge its liability.

Possible forms of a shared pension for the ex-wife

If the pension to be shared is a personal pension or an occupational pension of the defined contribution (money purchase) type, then the form of the pension for the ex-wife is simply a fund of units (or equivalent) in the pension policy or scheme.

In a defined benefit (final salary) scheme the situation is more complicated. First the pension rights of the scheme member have to be expressed in the form of a capital value.  This will normally be the CETV. The ex-wife can then have a pension bought for her - based on her own age at the time of the share. Thus, even after a 50/50 capital split, the two remaining pensions, one for the member and one for the ex-wife, will not usually be equal in amount - although their capital values will be equal.

It is required for a defined benefit scheme that the value-for-money implicit in the calculation of the pension for the ex-wife should be the same as that which the pension scheme gives to its new members when it accepts CETVs from other pension schemes.

Pension sharing as it affects the scheme member

Where the pension is of the “accumulating fund” type, that is a Personal Pension or defined contribution (money purchase) scheme, the situation is usually straightforward. The scheme member has the value of his own fund decreased by the amount of the pension share. Thus, for example, if it is agreed to share on a 50/50 basis, the scheme member simply has his holding reduced by one half. The pension scheme then continues as before with the member’s future contributions being added to this diminished fund.

There can be complications if the pension policy is with profits and there are questions regarding the amount of terminal bonuses that can be valued.

In schemes where it is the benefits that are defined, usually by reference to the salary near retirement, the situation is more complicated. As described above, the ex-wife will be granted a pension the amount of which is not equal to the pension scheme member’s pension even if the share has been on a 50/50 basis. (The values of the two pensions will be equal.)  

The amount of the member’s pension that has been given up will be recorded at the time of the pension share, and this will be increased in accordance with inflation as specified in the scheme rules. The increases will usually be “Limited Price Indexation” which is inflation as measured by the Retail Prices Index, but limited so that the average increase between the time of the share and retirement does not exceed 5% per annum. When the scheme member reaches retirement age the pension is calculated in the usual way.  It is then reduced by the amount of the pension given up at the time of the pension share, with this reduction indexed as described above.

Pensions sharing charges

The Regulations clearly establish that the obligation for meeting the charges falls on the divorcing couple, except to the extent that the pension scheme has to incur costs in setting up computer and other systems to carry out the administrative work.

The charges which the pension scheme can impose on the divorcing couple must relate to the actual costs incurred by the pension scheme and must be reasonable. They can be paid by the pension scheme member, the ex-wife or by a combination of them. They must be paid at the time of establishing the pension share either in cash or by reducing the value of either or both pensions. In the absence of a choice being exercised, the default position is that they will be deducted from the value of the pension scheme member’s pension rights.

The Government has the power to impose a maximum amount on these charges. At present this power is not being used, since the Government was anxious not to impose a maximum which could become a standard charge. It is expected that the charge will generally be in the range £750 - £1,000. It is unlikely to be wise, therefore, to pursue a pension share where the value of the pension is small, say less than £10,000 or so, since the cost of the share will absorb a disproportionate part of the value of the pension.

Implementing a pensions share

The Regulations also set out a regime of what actions are required and within what timescales. These requirements apply to both the solicitor on behalf of his client and to the pension scheme. Some of the timescales are quite short. It is vital that the process is carefully managed to ensure that the requirements are met and that the pension scheme discharges its obligations correctly.

Harry H Smith is a partner with consulting actuaries A R H Collins & Co, specialising in the valuation of pension loss