Avoiding surprises

So pension sharing has been agreed, hopefully after considering the merits of offsetting against sharing, should that have been an option.

Agreement on a pension share will normally have taken place some time before the divorce, normally on the basis of valuations obtained at the relevant date. While, in the majority of divorces, the division of most matrimonial assets will have been settled on or before the date of financial agreement, the pension share, by law, cannot take place until after the divorce has occurred. And it is that delay that can lead to surprises at implementation.

The decisions that are taken at the point of agreement, typically, will be based on information obtained as at the relevant date. However, it will always be wise to obtain updated information about all pension rights at the time of financial agreement, to identify any significant changes that might have occurred in those rights; that knowledge could well change decisions that are made at the time of agreement, both to reduce the risks that could undermine the intended pension share, as well as to optimise the outcome for one or both parties.

Two other points are worth noting. First, in agreeing to a pension share, most of the risks that could undermine the intention of the share between agreement and implementation, fall to the wife; however, there are some risks for the husband. Secondly, while, typically, the share is expressed as an amount, it is important to remember that the outcome of a share for each party always emerges in the annual pension that each will ultimately receive; the amount and the CETV are simply a means of conversion.

Consider intervening events

To identify the risks that should be managed, the events that could occur between agreement and implementation need to be considered. These include variously, death (of either party), transfer of the original pension rights to another arrangement, retirement of the husband, a change of health of the husband, underfunding in final salary schemes, and a “crash” of the CETV. These are considered further below.

Death before acceptance

If either party were to die prior to the acceptance of the sharing order by the pension arrangement, then the share will not proceed. Clearly this possibility should have been covered, either in the agreement or by other actions, and certainly if death comes as a financial surprise to the wife (or her beneficiaries) then she cannot have been well advised.

Transferring rights

If the husband transfers his pension rights before the date of implementation, the wife’s expectations can be severely affected. Obviously if the transfer is to an overseas pension arrangement, the pension sharing order will fall; at best, there will be significant cost in pursuing the husband, and there will be a very significant delay beyond the date of the divorce in obtaining any settlement. However transferring pension rights between UK pension arrangements can also result in a significant change in the expectations that may have been set on the basis of the information obtained at an earlier date. These typically will occur when transfer takes place from a pension arrangement that is offering an internal share (i.e. pension rights being offered within the scheme), and can lead to significant changes either in the amount of pension that the wife may have been expecting, or in the commencement date of that pension.

Transfer of pension rights will also lead to practical difficulties at implementation – particularly if that is not discovered until after divorce. It would be usual for all the scheme information relating to sharing to have been obtained as part of the process to establish relevant date values, long before the divorce. Decisions will have been made at that time on the basis of that information; in addition it is possible that a qualifying agreement will have been drawn up. If the pension rights to be shared have subsequently been transferred to another arrangement, then the whole process will have to be repeated with the administrators of the new pension arrangement.

If the husband retires

Retirement of the husband will invariably lead to an outcome that results in the wife’s expectations not being met – and remember that retirement will not necessarily mean that the husband is ceasing employment. Any pension credit for a wife that emerges from pension rights that are in payment to the husband can only be taken in pension form. It would be a normal for a wife to expect to receive 25% of any pension credit in the form of a tax-free cash sum on her retirement, but this is not permissible if the husband has commenced his pension, and, as would almost always be the case, taken part of his rights in the form of a tax-free cash sum.

So, not only does this mean that the wife will be taxed fully on her pension credit (in the form of income tax on her pension), she has also clearly suffered a significant loss in utility. Basically the husband, by commencing his pension, will have “grabbed” the whole of the tax-free lump sum. The final point to note is that, on the date the husband retires, the value of his pension rights will drop significantly – by the amount of the tax-free lump sum he takes. This will not be an issue if the amount of any agreed share is lower than the reduced value of his rights. But it would be an issue if it had been agreed, as part of the financial negotiation, that a high proportion of his rights at the relevant date were to be shared, since it is likely that there would be insufficient value in the remaining rights to meet the agreed share.

Health issues

The poor health of the husband at the date of implementation could also lead to unwelcome outcomes, particularly where his pension has commenced by that date. If the husband’s health is known at the date of agreement, then the potential outcomes could be anticipated, but if a significant deterioration of health occurs after agreement is struck, surprises can happen. While it would be exceptional for any pension arrangement to request specific details of a scheme member’s health in order to calculate a CETV for inclusion in matrimonial assets, some schemes will retain the right to do so at the date of implementation; this reflects the reality that, for pension schemes, a quotation has no financial consequences for them, but sharing does.

Clearly, if the scheme requests information about the husband’s health (normally at the expense of the scheme member), and bases the CETV on a reduced expectation of life, then it could be significantly reduced from the “standard” CETV. The risk, of course, is that financial agreement will have been reached on a valuation of assets on one basis, and the share takes place using an entirely different basis – even if economic conditions have not changed. The impact on the husband’s annual pension, because that is what ultimately matters, could be devastating – and this would occur well after financial agreement had been reached.

Underfunding pitfalls

Underfunding is particularly difficult to deal with in the context of Scottish family law. First, it is important to note that underfunding applies only to private sector final salary schemes – it does not apply to unfunded public sector schemes where the taxpayer shoulders the burden of ensuring that pension rights are paid in full.

The first problem with underfunding in Scottish divorces is that there are three important dates to consider: the relevant date, the date of any agreement, and the date of implementation. The situation with regard to underfunding can vary at each – so that means that agreement could be struck on one basis, and then implementation take place on another. It would also be wrong to think that the funding situation of a scheme is automatically and continuously mirrored in the CETVs that might be paid: changes in value could happen quite suddenly, and will be driven by trustees’ and employers’ decisions, as well as the legislation governing pension schemes. The second problem is that the use of the amount (a method of sharing that is only available for divorce actions raised in Scotland) was not properly thought through by the legislators where underfunded schemes are concerned.

Underfunding and pension sharing

When a scheme is underfunded on the date that a pension share is implemented, there is provision in regulation 16 of SI 2000/1053 (the Pension Sharing (Implementation and Discharge of Liability) Regulations) to allow the scheme to reduce the amount of the pension credit by the extent to which the scheme is underfunded. This legislation was clearly intended to deal with sharing instructions issued as a percentage (the only form in which a sharing instruction can be issued south of the border), but it is being applied by some schemes to sharing instructions issued expressed as a sterling amount. So for instance if the scheme is reducing CETVs by 25% at the implementation date, due to underfunding, then an instruction to share £40,000 will result in only £30,000 being transferred – which might be difficult to explain to the client if not anticipated! And if the scheme was also reducing CETVs by 25% at the relevant date, the wife suffers twice from the same level of underfunding – a most unfair outcome. Finally, if the husband prevaricates then the amount he will lose as a pension debit will be even less as his CETV increases over time. Of course, the effect on the wife may be able to be mitigated by electing for an internal share, but generally that will constrain the form of the wife’s pension rights.

However there is another aspect to underfunding that lawyers must take care to recognise when advising the husband, when he is their client. Irrespective of the impact on the wife, if a share for an amount is applied in an underfunded scheme, then it will almost always be the case that the reduction in the husband’s pension rights will represent a very poor financial outcome for him. A pension share is, to all intents and purposes, a transfer of pension rights – but no reputable financial adviser would advise such a course of action in these circumstances. So it is reasonable to ask whether a lawyer should allow a share to proceed in these circumstances without intervention.

Where it is clear that pension rights are being “sold” cheaply, there is one strategy that the husband might adopt to protect valuable pension rights. The pension regulatory regime operating from April 2006 allows very much more to be invested annually in pension rights. So for instance it would be possible to invest in an existing, or even a new, pension arrangement to create pension rights to be shared. This would not only help to protect valuable pension rights, but also allow them to be secured at an attractive cost because of the tax reliefs that would apply – with each £100 of pension to be shared only costing £78 for a basic rate taxpayer and £60 for a higher rate taxpayer.

If the CETV goes

And, finally, we will touch briefly on the impact of a CETV crash. Many of the issues that should be considered in relation to a dramatic reduction in the CETV after the relevant date have been covered above. However there is one other issue that is worth considering that is best illustrated by a simple example. Let us assume that the husband’s assets at the relevant date include pension rights with a value of £50,000. It is agreed that £45,000 should be shared. Between the relevant date and the implementation date, the husband contributes a further £7,000 to the pension arrangement. However at the implementation date the value of the arrangement has dropped to £40,000. When the sharing order is issued, several unfortunate consequences occur: first, the pension credit for the wife will be £5,000 less than anticipated – so she will be unhappy; secondly, the husband will lose all the rights he acquired after the relevant date – and indeed some he had not intended to share; and, finally, the lawyers for each side may have some explaining to do!

To conclude…

It should be clear from these articles that there are more matters to be considered regarding the valuation and treatment of pension rights than might at first be thought. Hopefully readers of these articles will now understand better how to recognise the traps that exist, and will be able to manage them in a way that means giving the best advice to their clients.

In some areas, matters could be made significantly clearer and fairer if the Executive act to amend the (Scottish) valuation regulations. In the meantime, it will be up to family lawyers to ensure that where pension rights form a material part of the matrimonial property, they avoid troubling the PI insurers by giving the best possible financial advice.

John Buchanan is an actuary with Collins Actuaries, Edinburgh and Glasgow. Parts 1 and 2 of this article were published respectively in the April and May issues