Technically, there are still three options to deal with pensions in divorce settlements – offsetting, earmarking and pension sharing – but are they all still viable in today’s landscape? All of the options are impacted in some way by the changes we have seen over the last 11 years, so they may need to be revisited if possible. Table 1 sets out the options as they stand.
Offsetting
Offsetting pensions against other assets is the easiest way to deal with pensions in a divorce. Given this has no impact on either party’s lifetime limits or pension protections, it may be the most preferable way to deal with things. However, there are issues that may arise in the case of offsetting today that may well not have been an issue years ago.
The biggest is funding pensions in the future for the ex-spouse with little or no pension. Historically, annual allowance levels went all the way up to £255,000 a year. These levels might have seemed excessive, but when an ex-spouse has received a payment due to offsetting, they may want to contribute as much as possible to a pension as quickly as possible.
The amount they can contribute is now restricted to £40,000, or even less, which could easily be used up if they have cash or assets and don’t need to use earned income.
Earmarking Orders
Earmarking Orders – or Attachment Orders – were the forerunner to pension sharing, and the only option (other than offsetting) prior to the Welfare Reform and Pensions Act 1999. Earmarking Orders were typically drafted to make a lump sum payment or pay a percentage of income to the ex-spouse when the pension was in payment.
The flaw in the system was that the decision of when to draw benefits was at the discretion of the member, (unless it was specified in the order, which was rare) so if the divorce was acrimonious, the member could delay drawing the pension or not draw it at all.
Earmarking Orders ceased on the member’s death or on the remarriage of the ex-spouse. They were drafted at a time when pensions freedoms and flexibility was never envisaged and these new freedoms, such as drawing an uncrystallised fund pension lump sum (UFPLS), or nil income from flexi-access drawdown, can have the unintended consequences of circumventing the requirements set out in the order unless the details in the order are very specific.
In most cases, the order will cease on death, so nothing will be received at that point either. This is because Earmarking Orders simply specify the amount of pension commencement lump sum (PCLS) or income that has to be passed over to the ex-spouse when they are accessed and don’t give a deadline for access.
The flexibility of income is also an issue because what the ex-spouse thought would be a regular income in retirement could turn out not to be. It could either be erratic or a single lump sum that will be taxed at the original member’s marginal rate of tax, which is unlikely to be beneficial to the ex-spouse.
It is possible that the ex-spouse never receives benefits if the original member chooses not to access them. Because of this, Earmarking Orders should really be confined to the history books. Where there have been historical Earmarking Orders put in place, the possibility of these being replaced by a Pension Sharing Order should at least be investigated if feasible.
The biggest issues with earmarking are the lack of a clean break and the fact the original pension member remains in control of the pension entirely.
On the flip side of this, though, the original member will be restricted on the pension they can build because all of the benefits remain theirs and are tested against their lifetime allowance even though they shouldn’t benefit from the whole income in retirement.
However, the ex-spouse is able to build up funds in their own name using their own lifetime allowance (LTA), irrespective of what they may receive, because of the Earmarking Order.
Sharing
Pension sharing is now the more modern option, which is generally used by most instead of earmarking because of the clean break it provides. There are still issues to be considered when opting for a pension share that can have impacts on both parties.
In most cases, the member will be able to remain in the scheme in which they currently sit, and the ex-spouse will need to take advice to decide where the benefits should be held after the Sharing Order is in place.
The ex-spouse may also need ongoing financial and investment advice to ensure that the benefits provided are as intended at retirement.
The Sharing Order will mean the benefits of the original member are reduced and given to the ex-spouse, which could cause LTA issues in the short and long term.
State pension
Sharing of state pension or national insurance records has previously been possible, but since the introduction of the new state pension this flexibility has been severely restricted.
For those who reach the state pension age after 6 April 2016, it is only possible to share the protected pension amount. In many cases, this will be very small because it is the difference between the starting rate (the amount you would get under the old state pension rules at 6 April 2016) and the new state pension rate.
Transitional protections and the LTA
Sharing or earmarking pensions on divorce will have an impact on both parties’ ability to build up pension funds in the future. Although earmarking uses up the original member’s LTA, there is no impact on any of the transitional protections because no funds move across to the ex-spouse.
Pension sharing can be more complex. All of the implications of the Sharing Order need to be considered before the order is put in place or funds are put into pensions to rebuild the original member’s retirement plans.
For those with primary protection, if too much is given away to the ex-spouse they may well lose primary protection, even though they still have benefits in excess of the allowance.
What actually happens is the amount that is given to the ex-spouse is taken off the value used for primary protection (no account is taken of any growth since A-Day), and if this brings the value to below £1.5m then primary protection is lost.
If the funds have grown significantly since A-Day, then it is very likely that primary protection will be lost, but the original member will still have benefits worth in excess of the LTA.
However, should the recalculated primary protection figure still be in excess of £1.5m, the original member will retain primary protection, but with a recalculated factor. This doesn’t impact on any protected tax-free cash if primary protection of any level is retained.
The receiving ex-spouse could lose their enhanced protection if the monies aren’t transferred into an existing pension. This is a real issue if the original member is in a scheme that doesn’t allow pension credits to leave the scheme.
But it will be rare that someone receiving a pension credit would already have such significant benefits themselves.
It may also be possible for the receiving ex-spouse to claim extra lifetime allowance, but this is only possible if the benefits being shared were crystallised and the divorce occurred after A-Day.
The reason behind this is to avoid the funds being tested twice. In fact, they will be tested twice, but the ex-spouse will have their lifetime allowance increased by the amount they have received in the Sharing Order.
Legal and financial advice
Pensions and divorce are a complex area and it needs those giving legal advice to request help from financial advisers to ensure that the best outcomes are reached.
There is clearly a need to revisit some previous Earmarking Orders to ensure they still meet the needs of the ex-spouse given the issues that have been introduced by pensions freedoms.
Claire Trott is head of pensions strategy at Technical Connection
