TECHTALK BERNADETTE LEWIS PENSION SHARING PENSION OFFSETTING

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1 TECHTALK This article originally appeared in NOV 17 edition of techtalk. Please visit for the latest issue. PENSIONS AND DIVORCE: SHARING AND ATTACHMENT ORDERS EXPLAINED Divorce settlements often result in pension sharing orders, although pension attachment (earmarking in Scotland) is still available. We explain the main consequences for pension benefits. BERNADETTE LEWIS Bernadette joined the group in She has over 35 years experience in Financial Services with both intermediaries and providers. She has broad and deep technical experience across pensions, protection, tax and trusts. Many peoples homes and pension funds are their most significant assets. This means pension benefits are normally taken into account when sorting out the financial settlement between divorcing married couples or civil partners going through dissolution. (All subsequent references to spouses divorcing also cover dissolutions of civil partnerships unless specified otherwise.) In England, Wales and Northern Ireland, the financial settlement is generally based on the value of all the pension rights each spouse had when they split up. The divorcing couple apply to the court for a pension sharing or attachment order. In Scotland, only the increase in the value of each spouse s pensions between the date they married and the date of separation is taken into account. The sharing or earmarking might be achieved by a legally binding agreement instead of a court order. PENSION OFFSETTING It s also possible to use offsetting a clean break option that leaves pension benefits undisturbed. For example, one ex-spouse might keep their existing pension benefits in their entirety while the other keeps the marital home. PENSION SHARING Pension sharing orders are available where divorce proceedings began on or after 1 December 2000, or for dissolutions of civil partnerships from 5 December Pension sharing orders are a clean break option, which award the member s exspouse a percentage share of the cash equivalent transfer value (CETV) of the member s pension scheme. If a scheme has more than one arrangement, the same percentage applies to them all. If someone has more than one scheme, the pension sharing order can award the member s ex-spouse different percentages of each scheme.

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3 A pension sharing order creates a pension debit against the member s rights, matched by a pension credit for their ex-spouse. The exspouse can normally transfer their pension credit into their own pension arrangement then deal with their pension credit benefits as they wish. Some public sector schemes will only provide the member s ex-spouse with an internal pension credit, so the ex-spouse becomes a pension credit member with their own separate rights, but still subject to the scheme rules. Other schemes can offer this option, but must also offer an external transfer. Pension sharing is also an option for crystallised pension benefits. If the crystallised benefits have been used to provide an annuity, the ex-spouse can either use their share of the CETV to continue to receive an annuity from the existing provider, or take an external cash transfer to make their own choice of pension arrangement. The member s annuity is reduced to take account of the pension debit. But it might be possible to re-set up their annuity on a single life basis if it originally provided for a spouse s pension. Pension schemes have four months to implement a pension sharing order, starting from the later of the date the order takes effect, and the date the administrators/ trustees receive all the required documents and information. While you d expect the ex-spouse to want to sort this out quickly, delays of several years are not unknown. Most providers won t act until they receive written transfer instructions from the member s ex-spouse in respect of their pension credit. In the meantime the policyholder still has the right to claim or transfer benefits in the usual way. The pension debit member can normally rebuild their pension benefits. PENSION DEBITS AND TAX When a pension sharing order comes into effect, the CETV creates a pension debit against the member s benefits. This directly reduces the value of the benefits in money purchase schemes and leads to an actuarial adjustment in defined benefit schemes. If the debit comes out of uncrystallised funds, this reduces the value of benefits tested against the member s lifetime allowance (LTA) when there s a subsequent benefit crystallisation event (BCE). This might reduce the likelihood of the member suffering an LTA charge. A pension debit has no effect on a member s scheme level protected tax-free cash, even though it involves a partial transfer out of the member s benefits. HMRC s Pensions Tax Manual (PTM) section PTM confirms this. who ve accessed benefits flexibly being caught by the money purchase annual allowance. There can also be disadvantages for someone with individual protection 2014 or 2016 (IP 2014/ IP 2016), as a pension debit can reduce the value of their protected LTA. For IP 2014, a pension debit from 6 April 2014 onwards retrospectively reduces the value of the member s pension savings originally used to calculate their protected LTA as at 5 April For IP 2016, pension debits from 6 April 2016 onwards adjust the value of their pension savings as at 5 April When calculating the deduction, the pension debit is reduced by 5% for each full tax year that s elapsed since 2013/2014 for IP 2014 and since 2015/2016 for IP This could result in someone losing all the benefit of IP 2014 or IP 2016, and reverting to the standard LTA if they have no other form of protection. The reduced LTA only applies to BCEs after the effective date of the pension debit. EXAMPLE Danny has IP He had 1.7 million of pension savings on 5 April 2014, making his protected LTA 1.5 million. Danny crystallised 600,000 via flexi-access drawdown in December 2015, taking tax-free cash but no income. That left 60% of his protected 1.5 million LTA available or 900,000 in monetary terms. Danny got divorced and a 450,000 pension debit came into effect on 15 June As two complete tax years had passed since 2013/2014, there was a 10% reduction in the pension debit deducted from the value of his pension savings for IP 2014 purposes (from 450,000 to 405,000). That reduced the value of his IP 2014 to million. In monetary terms, his remaining available LTA became 60% of million or 777,000. Depending on fund growth assumptions, Danny could consider rebuilding his pension fund via further contributions, as he s not caught by the money purchase annual allowance. The pension debit member can normally rebuild their pension benefits. However, there can be barriers to this, such as losing enhanced or fixed protection. There s also the possibility of higher earners being caught by the tapered annual allowance, or those

4 Pension credits can adversely affect people with enhanced or fixed protection. PENSION CREDITS AND TAX When a pension sharing order comes into effect, the CETV creates a pension credit for the member s ex-spouse. A pension credit isn t pension input, so it has no effect on the recipient s annual allowance. The credit becomes part of the recipient s own pension pot and is tested against their own LTA at any of the usual BCEs. If the pension credit is paid out of funds the original member crystallised from 6 April 2006 onwards, it s termed a disqualifying pension credit. The recipient can t take any tax-free cash from this source. However, they can still choose when to use the credit to provide pension benefits for themselves subject to minimum pension age legislation and any relevant scheme rules. They can benefit from LTA enhancement via a pension credit factor see HMRC s PTM for full details. Some pension credit members who made a claim by 5 April 2009 will have an LTA enhancement via a pre-commencement pension credit factor. This takes account of the pre-6 April 2006 treatment of pension debits and credits. Pension credits can adversely affect people with enhanced or fixed protection. It s possible to pay a pension credit into an existing money purchase arrangement without losing these forms of protection. However, paying a pension credit into an existing defined benefits or cash balance arrangement might lead to benefit accrual and the loss of protection. In addition, the recipient automatically loses protection if they pay a pension credit into any new arrangement. (HMRC s PTM covers enhanced protection. Similar rules apply to fixed protection.) TRANSFER DATE / EFFECTIVE DATE The transfer date for a pension debit is the effective date of a pension sharing order. Provided a valid appeal hasn t been lodged, the effective date is the later of the date of the decree absolute or 28 days after the order has been made. (Based on regulation 9 of the Divorce etc (Pensions) Regulations 2000 and the timescale for lodging an appeal against a pension sharing order.) PENSION ATTACHMENT (EARMARKING) Pension attachment orders are still called earmarking orders in Scotland. They can cover all the main types of UK occupational and personal pension schemes, but can t apply to state pensions. This option has been available for divorce proceedings since 1 July 1996 and for dissolutions of civil partnerships from 5 December In England, Wales and Northern Ireland, an attachment order can specify that some or all of a member s pension benefits must be paid to the ex-spouse when the member starts taking benefits. The order can also cover tax-free cash and lump sum death benefits. In Scotland, an earmarking order can only cover tax-free cash and lump sum death benefits. Survivor s pensions on death can t be earmarked in any of these jurisdictions. All these orders normally apply to benefits earned up to the divorce date. But if an order doesn t specify this, it covers all the member s benefits up to their retirement date. The order can: Specify that a member must take any available tax-free cash and pay all or part of it to the ex-spouse. Restrict tax-free cash to maximise the pension benefits available to the ex-spouse. Specify that any lump sum death in service benefits are paid to the ex-spouse by instructing the scheme administrator/ trustees to do so, or instructing the member to nominate their ex-spouse. Cover a lump sum payable on death under a guaranteed annuity. While most couples would probably prefer the clean break option of a pension sharing order, there can still be a role for pension attachment. It s sometimes the only practical solution, such as when the member belongs to a small self-administered scheme and the main asset is the company s own property. Or there might be a significant age difference: a pension credit recipient can t normally access pension benefits before age 55, but there s no minimum age requirement for receiving an income from their exspouse via pension attachment. Pension attachment does have disadvantages. The ex-spouse only receives the benefits when the member takes theirs, with personal pensions offering considerable control over when and how to take benefits. Also, the ex-spouse loses their entitlement to pension benefits if the member dies first, or on remarriage although they can cohabit to avoid this. Remarriage shouldn t normally affect the ex-spouse s entitlement to any lump sum benefits, but the order will specify this. The member can normally transfer their benefits even if an attachment order is in place, although some orders require the ex-spouse to give their consent. In all cases, the transferring scheme must inform the ex-spouse of the transfer and pass relevant information to the new provider, which must then comply with the order.

5 PENSIONS ATTACHMENT AND TAX Where an attachment order is in place, any crystallised benefits are tested against the member s LTA, with no effect on their ex-spouse s LTA. The member is liable to income tax on the whole pension, including the amount paid to their ex-spouse. The ex-spouse has no income tax liability in respect of the payments. This might not be tax-efficient, if the ex-spouse has unused personal allowance, or is taxed at a lower rate than the member. To avoid confusion, the attachment order should explicitly state that the ex-spouse is entitled to a percentage of the member s net pension benefits after tax. EXAMPLE Michael s pension benefits are subject to an attachment order following his divorce from Kathleen. He receives pension income of 31,500 a year. The order specifies that Kathleen is entitled to 50% of the net benefits after tax. After allowing for his other income, Michael pays higher rate tax of 12,600 on the pension benefits, so both he and Kathleen are entitled to 9,450 of the net benefits. Even though Kathleen is a basic rate taxpayer, she can t reclaim any of the tax Michael has paid. Michael and Kathleen s divorce proceedings started before 1 December 2000, so they don t have the option of applying to the court to substitute a pension sharing order. PENSION PROTECTION FUND The Pension Protection Fund (PPF) protects members of defined benefit schemes if the sponsoring employer becomes insolvent and the scheme has insufficient assets to pay benefits of at least the level the PPF would provide. PPF compensation then replaces the pension benefits. If the PPF takes on a scheme, it takes any existing pension sharing and attachment orders into account. If someone gets divorced after the PPF takes on a scheme, compensation sharing and attachment orders are available, but a pension credit recipient can t take a CETV to their own choice of scheme. Ex-spouses receive benefits based on the PPF s compensation rules. STATE PENSION Pension sharing orders can cover additional state pension for those who reached state pension age (SPA) by 5 April Or the protected payment element of the new state pension for those who reach SPA from 6 April Additional state pension is based on SERPS and the state second pension. The protected payment element of the new state pension is based on the converted value of additional state pension as at 5 April 2016 under the transition rules. Divorcees reaching SPA by 5 April 2016 who haven t remarried are sometimes able to use their ex-spouse s national insurance record to increase their basic state pension without affecting the ex-spouse s entitlement. This option doesn t apply to anyone reaching SPA from 6 April INTERNATIONAL ASPECTS Separating couples face complications if they re divorcing overseas and want to take UK pension benefits into consideration. They ll need to obtain a UK court order before a UK provider will implement any pension sharing or attachment provisions. If a UK provider takes the risk of acting on a foreign court order, it might make an unauthorised payment leading to tax charges. As the couple may need to establish a UK connection in order to obtain a valid court order, they should seek specialist legal advice at an early stage. There can also be problems for couples divorcing in the UK courts where one or both spouses have overseas pension benefits. The 2016 case of Goyal v Goyal points to the UK courts accepting that pension sharing legislation doesn t extend to overseas pensions. Again, it s a question of seeking specialist legal advice on suitable financial remedies. It s possible to transfer a pension credit to a qualifying recognised overseas pension scheme (QROPS), but the options may be more restricted since the 2016/2017 introduction of a 25% overseas transfer charge for transfers to QROPs in circumstances that don t meet specified conditions. Every care has been taken to ensure that this information is correct and in accordance with our understanding of the law and HM Revenue & Customs practice, which may change. However, independent confirmation should be obtained before acting or refraining from acting in reliance upon the information given. Scottish Widows Limited. Registered in England and Wales No Registered office in the United Kingdom at 25 Gresham Street, London EC2V 7HN. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Financial Services Register number