The Courts’ approach to pensions

The courts have struggled to define pension rights: should they be treated as capital, albeit on a deferred basis, or do they represent a deferred income?

Pensions are unlike any other asset or income, and their unique nature means the percentage to be transferred on pension sharing can be calculated by reference to either:

1. the capital value, known as cash equivalent (CE), or
2. the income stream the pension will produce for the parties

Often parties may wish to equalise their retirement provision by sharing the pension resources.

A party may intend to draw a tax free lump sum at retirement, which represents capital, and usually, the rest of the pension fund will be accessed as deferred income. If a pension is already in payment it can be treated as current income.

Merely splitting the CE 50:50 will not necessarily produce equal pension income on retirement because, for example respective ages and life expectancies of the parties, and the commercial reality of what the pension credit will buy the pension recipient in terms of retirement income.

Another approach can be to provide the pension recipient with a percentage split that will equalise pension benefits on retirement.

In many cases an equal sharing of pension rights will not produce a fair result in any event, because of the parties’ needs, ages, length of the marriage or because the pension rights are non-matrimonial assets.

Options available

The options available when redistributing pension rights are:

Offsetting

Pension offsetting is the process whereby the value of the pension resources is set against the value of other assets held between the parties. Offsetting does not involve the court making any pension orders. The pension rights remain with the pension member. It works by adjusting the distribution of non-pension assets to take into account that one party will have less valuable pension provision. It can often be used in cases when one party wishes to retain the family home at the expense of future pension provision. It is also an option where the pension rights cannot be shared, for example an overseas pension.

The starting point is to obtain up-to-date valuations for all the parties’ assets, liabilities and income including pension assets. The difficulty remains that pension assets are not the same as other assets.

Valuation calculations for pensions are complex. The usual method of calculation is at the CE value. If the pension is in payment, this is sometimes referred to as the cash equivalent benefits (CEB). Not all CE valuations are equal. A CE for a final salary scheme (particularly a public sector scheme) may be considerably more valuable in terms of the benefits it provides pound for pound than a money purchase scheme.

Any CE calculation is gross of tax. If the parties are younger than retirement age, the pension rights will consist of a lump sum at retirement (called the pension commencement lump sum (PCLS)) and a pension income for life. The lump sum will be tax-free but the pension income will be subject to income tax. It may be appropriate to adjust the pension valuation to allow for the average rate of income tax over the individual’s lifetime.

The services of a pensions expert will be required to complete this calculation. The relevant tax considerations will also need to be ascertained in respect of any non-pension assets to be offset (such as investment property).

A CE calculation is not the only methodology for calculating the appropriate amount to offset and it may be possible to agree to use an alternative. The most common methodologies used are:

1. net replacement value
2. net actuarial value, and
3. Duxbury value (essentially a calculation of capitalised maintenance).

Pension sharing

Pension sharing is the method by which an existing (shareable) pension arrangement is split and divided between the parties following divorce, nullity or dissolution proceedings. A pension sharing order transfers a part (or the whole) of a pension from one party to the other, giving the recipient a separate pension fund that can be invested in the same scheme or in another external scheme (subject to the relevant scheme rules).

Pension attachment orders (originally known as earmarking orders)

A pension attachment order requires the person responsible for a pension arrangement (PRPA) to pay a percentage of the:

1. pension income, and/or
2. pension commutable lump sum, and/or
3. death benefits

available to one party when a pension becomes payable to the other party. In this way, the recipient attaches to the existing pension arrangement.

Financial advice

We cannot give financial advice, as this is an offence under the Financial Services and Marketing Act 2000. Giving financial advice would include suggesting that a client access pension funds to fund a lump sum payment, or that they might consider transferring out of a defined benefit scheme to a defined contribution scheme.

Instead clients should obtain independent financial advice early in the process and that they also understand any tax or annual or other allowance consequences of any proposed pension action. We therefore work closely with reputable financial advisers who can provide this assistance.