Pensions  

What you need to know when clients divorce

  • Describe the challenges of splitting assets on divorce.
  • Identify some tax issues.
  • Explain the issues with splitting pensions.
CPD
Approx.30min
What you need to know when clients divorce
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In England and Wales, there is no one formula for dividing assets upon divorce. Instead, how assets are divided will turn on the particular facts of each case, which allows for a ‘bespoke’ outcome. 

The courts can rearrange assets in almost any way imaginable via a toolkit of powers set out in the statute.

Even if settlement is achieved outside of court proceedings, all settlement negotiations take place in the shadow of our law, which provides guidance. Section 25 of the Matrimonial Causes Act 1973 lists a set of helpful factors that the court must consider, starting with the needs of any minor children of the family.

The landmark case of White v White [2000] provides that any proposed settlement must be held up against ‘the yardstick of equality’, inferring that settlement should provide for an equal division of matrimonial assets without discrimination between the roles played during the marriage.

The case of Miller and McFarlane from 2005 provides that to achieve fairness, we must consider three strands, namely needs, sharing, and compensation. In any case, the priority is that settlement must meet the needs of each party (albeit needs is a concept that changes according to the circumstances of the case). 

Such wide discretion enables spouses who are negotiating a settlement an opportunity to tailor it to their needs. As such, given the intersection of legal, personal and financial issues, advice from a lawyer and a financial adviser should be considered in tandem to secure the best possible outcome and avoid any surprises along the way. There are a number of key financial considerations for spouses and civil partners dividing their assets upon divorce. 

Valuing assets

The computation of all assets is a crucial first step in any case; one must know what assets are available before they are divided. However, the value of assets is often not what it first seems; consideration must be given to the tax treatment of each asset on disposal, so that a net value can be ascribed. This approach is most prevalent in cases involving the following assets:

  • Investment properties. It is crucial to seek advice on what tax may be payable on disposal. Tax is a liability (the same as costs of sale) that should be deducted to arrive at the value used for negotiations.  If property is owned abroad, advice about the tax implications in that jurisdiction must be sought.
  • Investments. Not all investments are equal when it comes to valuations. Whereas the value of a listed security can be found instantly, obtaining the valuation of a private equity investment – which may only be valued quarterly – can take time and effort. One must also be aware of the volatility of investments, which can fluctuate significantly in value – particularly in the case of  cryptocurrencies, which display daily volatility.
  • Pensions: Pensions are a complex area of financial planning, and so care must be taken in ensuring you know what sort of pension you are dealing with, and how to value it, as not all schemes are the same. Some valuations require the services of an actuary, whereas some can simply be done online. For those provided by an actuary, the valuation is set for three months and then expires, so again there is an emphasis on ensuring you are using an accurate valuation. Some pensions carry additional benefits, such as a guaranteed annuity rate, which is not reflected in the transfer value received. When these pensions are then valued on a real-life open market basis, the value can be higher than initially thought. 

If latent tax on an asset is not accounted for or deducted when considering the value, the impact can be severe. If one spouse retains an asset upon which tax will arise, they will end up with less than anticipated as part of the agreement. 

Tax efficiency

  • ‘No Gain, No Loss’. Spouses living together can take advantage of the ‘no gain no loss’ rule, meaning assets transferred between them are not liable to capital gains tax. Applying this to divorce proceedings, this is not available if the transfers are completed after the end of the tax year in which the separation occurs (though this time period is currently under consultation). Should assets be transferred outside of this window it could lead to significant tax bills, ultimately reducing the value of the matrimonial estate. 
  • Mitigation of tax. Different investment wrappers carry with them different tax implications for the underlying investments and how they are taxed on access. Therefore, when calculating the division of assets, it is important to understand the investments one is dealing with and their respective tax treatments. What looks like an equal division of assets on paper does not necessarily end up that way when the assets are realised. Equally, the tax position of each party may be different, so when deciding on the division of assets one must combine both the tax treatment of the wrapper and position of the individual, to find the most equitable and tax-efficient split.
  • Pensions. The tax treatment of pensions, particularly on divorce, is another complex area requiring careful handling. That said, there are some scenarios whereby splitting a pension can actually create a tax saving by bringing each individual’s pension benefits below the Lifetime Allowance, therefore increasing the net proceeds available. One must also be wary of the net value of a pension to the recipient (particular when offsetting), as receiving £100,000 in a pension will be worth less than receiving £100,000 in cash. 

Settlement Options 

Given the court’s wide discretion, there are myriad ways in which fairness can be achieved, and spouses are free to structure an agreed settlement with their own objectives in mind. Common considerations regarding the structure of settlements include: 

  • Whether one or other of the parties prefers to retain property or liquid assets over a pension share. If one spouse is entitled to a pension share, either spouse may suggest that that pension claim be offset in lieu of capital. This is not a straightforward calculation: pension capital and capital cannot be compared on a pound-for-pound basis. Often a ‘utility rate’ is applied to account for the benefit of receiving cash (which is liquid and can be invested) versus a pension share (which is illiquid, can only be drawn down upon in the future, and is taxed). This approach requires due diligence.
  • Whether a clean break is achievable; after all, there is a statutory obligation to consider whether this can be achieved. A ‘clean break’ means that capital and financial claims are dismissed once and for all and there is no continuing obligation for one party to pay the other spousal maintenance. The spouse with a higher income often wants to achieve a clean break, and this can often be achieved by an offer of a lump sum, which is construed as ‘capitalised maintenance’. The receiving party must give careful consideration as to whether this lump sum meets their future income needs, or whether they have sufficient resources and earning capacity to do so in any event. The ‘Duxbury calculation’ is the standard formula that is often used to calculate the lump sum required for a spouse to draw income for the rest of their lives. 
  • Cash flow modelling can be a valuable alternative to Duxbury, allowing for a more contemporary and sophisticated approach to assessing the capital required to provide an income stream. Cash flow modelling goes further by allowing individuals to build a bespoke model to show the financial implications of any proposed asset split. This will incorporate their dreams, worries and responsibilities, to achieve a settlement that affords them the financial future they desire.

Financial Stability

  • When devising a division of assets, risk must be considered, as it ties in with the volatility of an asset value, liquidity, and how the investment can be used in a financial plan. The greater the equity portion of an investment, the more volatile it will be – and within that, the volatility will also depend on sector, region, currency, and other factors. A prime example would be the difference in performance of ‘growth’ and ‘value’ stocks since the beginning of 2022.
  • Liquidity is often overlooked, as stability in the asset value tends to take precedence in the risk assessment. Key factors driving liquidity include the structure of the investment, the size of the underlying companies and the volume of trading of the asset. These must be known before concluding a settlement, as while the value of the investment may fit, what it can be used for as part of the recipient’s financial plan may be hampered by liquidity and access.
  • One must also consider the recipient’s risk appetite and financial background, as this will determine how appropriate any division of assets is. Although the headline valuation of an asset may make it appear suitable, its underlying qualities may mean that in practice it will not work for the recipient to own that asset. For example, someone who has no income and will rely on the investment to fund their lifestyle should not really end up with the more volatile and illiquid assets, if others are available in the matrimonial estate. 

Investment requirement

When building a portfolio for individuals, their environmental, social, and governance requirements must be taken into consideration, along with any ethical preferences, and the same applies when dividing assets upon divorce. This is not possible for all investment vehicles, however, if there is little flexibility in selecting the underlying holdings. As such, when assessing the division of assets, if one party has specific requirements and the other does not, this may impact which assets go to each individual.