The reality of pension sharing

Scottish family lawyers have been dealing with pension rights on divorce since the introduction of the Family Law (Scotland) Act 1985.  Since December 2000, they have had to do so within the context of the Welfare Reform and Pensions Act 1999, which introduced Pension Sharing.

My colleagues and I have been involved in providing advice, not just in Scotland but also throughout the whole of the UK, on the practicalities of carrying out a pension share.  Our experience has left us worried about the whole operation of this legislation, and the results that are currently being produced.  

We are not lawyers.  We are actuaries and pensions experts.  As such, we are seeing an area of great complexity dealt with all too frequently in a simplistic fashion, which will, in a number of cases, produce serious untoward, and probably unexpected, financial effects.  To give one simple example, we have seen cases where the intention had been to give away as a pension share about half of the pension scheme member’s pension rights, but the reality of the implementation was to leave the pension scheme member with close to nothing!

In these two articles, I will be assuming a basic knowledge of the legislation and regulations regarding both the valuation of pension rights for divorce purposes and also the operation of pension sharing.  I will explain why things can go very wrong, in many cases without the lawyer even being aware of a problem until long afterwards, and will give some examples of the types of problems that can and do occur.  

In this article, I will look at the problems encountered in coming to the point of decision as to how the pension rights should be taken into account.  In the following article, in the June issue, I will focus on the wording to be used and problems arising at implementation.  In particular, I will look at the specific problems that exist in Scotland (and also Northern Ireland), because of the requirement in the legislation to resolve issues at a date in the past, which, in Scotland, is typically the date of separation.

Why are we concerned?

Many family lawyers are failing to deal with pension rights on divorce in the best interests of their clients.  They are simply not appreciating the significant problems involved with pension rights.  In too many cases the lawyer is carrying out the formalities adequately, but is failing to think through the consequences of what is being implemented.  With pension rights, these consequences can be very significant indeed.

On a daily basis, we see two different types of situation where family lawyers are going wrong:

• When we receive an instruction to implement a share for a fixed percentage or amount, the lawyer has appreciated some of the problems of either drafting the order or agreement, or carrying out the implementation, and is seeking professional assistance for this.  In almost every such case, if prior advice has not also been taken, we find that he/she has advised the client on the basis of flawed or inadequate information about the pension rights, and the decision on the amount to share has been based on this advice.
• Sometimes our advice is sought on the nature of the pension rights, and our report is used as the basis on which to agree a division of the assets and the resultant amount of any pension share, but the lawyer then takes on the task of liaising with the pension scheme for the implementation.  While there is a proportion of cases where this will work, there are pitfalls, and we have seen some unfortunate outcomes where the effect of the resultant pension share was far from what might have been expected, sometimes leading to serious potential financial disappointment for one of the parties.  This could lead to the disappointed party seeking redress from his/her legal adviser.

Pension rights: What is so problematical?

What is actually so different between pension rights and any other matrimonial asset?

Pension rights are an entitlement to certain future financial benefits within a pension scheme.  The scheme may be personal, may be that of an employer (public or private sector), or may be a state scheme.  In all cases, however, it is an entitlement to future payments which are dependent for their commencement and continuation on stated conditions, and which will be paid over a very long period of time.  This asset cannot be sold, cannot be exchanged for cash in any way whatsoever (apart from the proportion that can be taken as tax-free cash at retirement), and cannot be assigned for value.  This makes the whole nature of pension rights very different from that of any other matrimonial asset.   

Pension rights also have the following very important features:

• Each extra day worked by the scheme member, and each increment in salary may produce extra pension rights.  This means that the value continues to develop.  This does not happen with most other assets.  While a house may change in value, it does so primarily because of market value changes.  The actual fabric of the house does not, in itself, grow.
• The value of pension rights is constantly changing.  Again, the comparison with the house is interesting, because while both change in line with market changes, the value of the pension rights can change for reasons that will be completely unintelligible and unpredictable to the layman.  This can apply in both directions.  One obvious example of this may be changes in stock market values, but there are many others such as changes in medium-term interest rates, changes in actuarial practice and professional guidance, changes in legislation or regulations, changes in the funding level of the pension scheme, changes in the investment policy of the pension scheme, and many more, including simply the passage of time.
• The value of the pension rights is not clear-cut.  There may be arguments between professional valuers as to the value of a house, but not as to what part of it is assessed.  Omitting the value of, for example, discretionary benefits, is akin to valuing a house without its kitchen.  The scheme will always use the CETV at the date of implementation in carrying out the share, but the effect of this can often be surprising, and very significantly different from expectations.

What are the problems?

There are five different stages to the treatment of the pension rights in a divorce settlement:

• Getting the information;
• Understanding the information;
• Deciding what to do;
• Drafting the appropriate wording;
• Implementation.

The remainder of this article looks at the issues that occur up to the decision point, and in the next article I will look at the difficulties in the last two stages.

Getting the information

There are two golden rules when starting to consider the pension rights:

• Get a full employment history from each partner;
• Do not make assumptions that any pension asset will be too small to be worthwhile.

Where an individual has been in employment earning more than about £4,000 per annum (in current money terms), there will ALWAYS be pension rights in respect of that employment. These will usually be in personal or employer pension schemes, but if these do not exist or are inadequate, there will be benefits in the State Earnings Related Pension Scheme (SERPS) or the State Second Pension (S2P). This means that almost everyone who has been in paid employment at any time since 1978 has pension rights of some sort. These should be taken into account as part of Matrimonial Property.

In our experience, family lawyers are frequently failing to take account of benefits in SERPS or S2P. This can be professionally risky. Where a person has been “contracted in” to SERPS for any reasonable period, the value of the benefits is very likely to exceed £20,000. We have seen values as high as £125,000. It must be stressed that these high values are not in respect of high earners. Indeed, in current money terms, SERPS takes no account whatsoever of earnings in excess of about £30,000, thus treating all who earn over this the same.

A particular point to note is just how valuable these benefits can be for low earners. Indeed in many marriages, the wife may have had a series of low paid jobs in apparently non-pensionable employment, and actually have acquired significant rights in SERPS, often more than her husband who has been in “contracted out” employment.

It is also unsafe to assume that there are no benefits in SERPS/S2P if someone has been in “contracted out” employment. This may seem illogical, but SERPS/S2P pays for some of the inflation proofing of the contracted out pension rights rather than the pension scheme itself, and thus a value exists for this aspect of these rights. We have seen cases where this limited value is in excess of £25,000 for a person close to retirement. Again, and for the same reason, these high figures can be in respect of moderate rather than high earners.

The other mistake that we see frequently is a focus on the current employment, with the mistaken assumption that pensions either did not exist in previous employments or were transferred into the current employer’s pension scheme. The employment history is the key to this. Periods of employment or self-employment for which no pension value is known should always be investigated.

Preserved pensions with former employers can be surprisingly valuable. For many years now, the pension scheme has been obliged to revalue these pension rights each year in line with price inflation. This has the effect of ensuring that the value does not become trivial, through inflationary changes, as has happened with some older investments such as life assurance policies or “frozen” deferred pensions from the era before these became inflation protected.

Understanding the information

Pension schemes are obliged to supply information to the family lawyer in respect of pension rights for which a pension share might be contemplated. This information is spelt out in The Pensions on Divorce (Provision of Information) Regulations 2000 (SI 2000/1048). It is not sufficient simply to request the scheme’s valuation, the CETV! This additional information is vital to an understanding of the pension rights under consideration. Amongst other things, it will reveal the effect of the state of funding of the pension scheme on the value quoted (a major problem at present with over 75% of private sector pension schemes being under-funded), and how the pension scheme will treat any discretionary benefits. How these affect what to do is considered in more detail later in this article.

Even with the CETV itself, we see the following problems recurring very frequently:

1 In some cases, the pension scheme will not quote a CETV that is calculated as at the Relevant Date. Worse, the scheme may not tell the lawyer that it is not calculated as at the Relevant Date, but simply quote the current CETV of the benefits, sometimes proportioning to include only those that accrued to the Relevant Date, often without any indication that they are doing so. This value is not satisfactory, and is likely to be very misleading if the time lapse since the Relevant Date is more than a few months. Pension schemes never need historical CETVs for any other purpose than a Scottish or Northern Irish divorce. Consequently, many do not have this facility available on their automated systems. Some have taken the view that the legislation does not require them to provide this information, and, to the best of my knowledge, this has not been tested.

2 On the other hand, some pension schemes are too helpful. They provide a CETV which is already apportioned for the period of the marriage, but unfortunately do not always make it clear that they have done so. There is a serious danger that apportioning will be done twice.

There is a further problem with apportioning caused by an ambiguity in the regulations. Paragraph 4 of The Divorce etc. (Pensions) (Scotland) Regulations 2000 (SSI 2000/112) specifies how the apportioning should be done, by multiplying the total CETV by a factor B/C. C is defined as “the period of membership … in the pension arrangement before the relevant date”, and B as that part of C “which falls within the period of the marriage”.

Pensions are accepted as deferred pay (Barber v GRE 1990). This means that pension rights are being acquired while the member is employed. No further pension rights are earned during retirement or after leaving employment. As section 10(5) of the Family Law (Scotland) Act 1985 (to which the relevant regulation refers) makes it clear that it is only that proportion of the pension rights “acquired during the marriage” that are counted as part of matrimonial property, it is clear that the intended interpretation of the regulation is to achieve this; common sense suggests this too.

However, the definitions of B and C in the regulation can be read as meaning the whole of the membership of the scheme, not just the earning period. If the regulation is applied in this way, it will produce ridiculous results. For example, if a pension scheme member retired before the marriage began, thus earning his entire pension rights outside the marriage, but the whole membership is taken into account, a value would be ascribed to these pension rights within the marriage. Worse still, the proportion that would be included would increase as time passed. This is clearly not the intention behind the regulation.

3 We see frequent errors in quoted CETVs. Remember that the pension scheme will not be paying out on the basis of any CETV it quotes to the lawyer, even if the end result is a pension share. Our experience is that less care is being put into the production and issue of these values than would apply to a CETV that might lead to an actual transfer out.

Deciding what to do

When pension sharing was introduced, the Government was very keen to see it used. Because it would provide pension benefits to divorcing wives, future reliance on state benefits would be reduced. However, the decision as to how to treat the pension rights has to be made in the context of the treatment of all the assets of the marriage. The net result will frequently be some combination of offsetting part of the value of the pension rights against some other assets, and sharing the balance of the pension rights.

We are often asked which is better: offsetting against other assets or sharing. Neither is better. Both are acceptable and sensible ways of dealing with the pension assets. Which will be used in any particular case, and the degree to which each will be used, will depend on the circumstances of the case. There is a third alternative: an attachment or earmarking order. I will not cover this in detail in this article. Suffice to say that there are virtually no circumstances where this would be better than a sharing order for the pension scheme member, and if a lawyer is considering using such an order, he/she would be well advised to take professional advice before doing so.

Many clients will have more than one pension right; indeed probably most clients will have once the SERPS benefits are considered. If a decision has been made to share, there is a major decision to be made as to which pension(s) to share. It is obvious that by sharing only one pension right the administration costs will be lower than sharing several. This, however, is not the whole problem. It is not even the major problem.

It may seem paradoxical to the pensions layperson, but it is possible to achieve the same result for the receiving spouse, with very different results for the scheme member spouse, depending on which pension right is shared. A very simple example based on a case we recently dealt with will show this:

Husband, Mr X and Mrs X were both in their early 70s. Mrs X had no pension rights, but Mr X had 2 pensions, both in course of payment from different private sector schemes. The first was for £6,500 per annum with a quoted CETV of £78,000, and the other was for £4,900 per annum with a quoted CETV of £73,500. Both pensions increased in line with inflation.

The agreed aim of the share was to give Mrs X £50,000 out of the value of the pension rights as a pension share. Here are the results to Mr X depending on where the share is effected:

What is important to both parties is the amount of pension they will receive each year in the future. The CETV is a figure of no importance to them whatsoever, as they can never have it available to them as cash. It is merely a tool for the pension scheme to work out the share, and, because different schemes calculate this value in different ways, radically different results can be achieved.

It is vital to seek professional advice whenever there is an option over which pension rights to share. The example above shows that there can be a difference where any two schemes are involved if the basis of calculation of the CETV differs.

There are, however, some situations where the choice of the wrong scheme will lead to serious consequences that may not be obvious to the pensions layperson. These are as follows:

• Where one pension right is in a final salary scheme, and the other is in a money purchase scheme (which includes personal pensions);
• For personal pensions, where one is invested in a with-profits fund, and the other is in an investment linked fund;
• Where any of the pensions is in an underfunded scheme, or is invested in an organisation with financial problems (e.g. Equitable Life).

Conclusion

The decision being made is about a set of pension rights stretching well into the future. As stated above it is very important to realise that the final result is not about an amount of the CETV. This is just a means to achieve an end. While the CETV is a capital value that can be put on the pension rights, the real asset is the pension rights themselves. It is payment of pension that will be received. That is the only way in which the bulk of these rights will be delivered.

It is important to realise that pension sharing is actually a financial transaction. Indeed in many cases it will be a very major financial transaction for the two individuals concerned, possibly the biggest this couple will ever transact. It appears to be the only such financial transaction which currently is not regulated, an exception that it is difficult to imagine the authorities allowing to persist.

It must be good practice, therefore, to take precautions when dealing with a pension share, and to all intents and purposes handle it as if it were regulated. There is a long history of the financial authorities blaming the adviser retrospectively when the scandal blows up, rather than accept their own deficiencies.

What then should the family lawyer do? The golden rule is to determine what the result of the pension share will be for the two parties involved, and then to ensure they are made fully aware of this. Where a decision is made by the client with full knowledge of the effects of that decision, the adviser must have done his/her duty. Indeed, the very act of getting this information will reveal to the family lawyer the pitfalls described above. If in doubt, seek professional advice.

In the follow-up article in the June issue of the Journal, I will look at the further problems that arise when drafting the order or agreement, and then having it implemented.