What happens to your pension when you get divorced?
Last week we looked at the CGT implications of transferring assets on divorce or dissolution, but we didn't look at what, for many people, is their largest asset other than their home, their pension. The ransacking of pensions is possibly what hits certain men (or women!) where it truly hurts.
A pension often represents the greatest entitlement to income of one or both parties to a divorce and it is compulsory that such entitlements are taken into consideration in divorce settlements.
The three key options available are offsetting pension benefits, pension attachment orders and pension sharing orders, and the method used can be negotiated by the parties involved through solicitors or left to a Court to decide in contentious cases. Courts normally prefer pension sharing to offsetting, but both are used more frequently than attachment orders, given the inherent risks and difficulties.
Offsetting pension benefits
The most common way to deal with pension benefits in a settlement is to take the value of pension rights into consideration but to equalise estates by transferring other financial assets of the marriage. A simple example would be where one spouse keeps their pension fund and the other keeps the family home. This method does make for a clean break and each party retains their own existing pension benefits.
Pension attachment orders
Pension attachment orders (formerly known as earmarking orders) have been available in England and Wales since 1 July 1996. One of the main problems with attachment is that it does not allow a 'clean break' between the divorcing couple.
Attachment orders do not transfer ownership of any of the pension to the ex-spouse. This means the member still has full control (subject to what the trustees will allow) over how the pension is run. In addition, the benefits are taxed at the marginal rate of the member who retains the liability for the income tax on the whole pension, even the part of the pension that is earmarked to the ex-spouse.
Some of the other drawbacks are as follows:
- benefits remain with member so the ex-spouse has no control over the timing of benefits and the ex-spouse has no control over the investment risk;
- income benefits cease on member's death, although a lump sum death benefit is may be earmarked in the attachment order;
- benefits cease on ex-spouse's death or remarriage; and
- if the member retires early on a reduced pension, this means a reduced pension for the ex-spouse as well.
Pension sharing orders (PSO)
With a PSO, the court awards a slice of the pension benefits (a pension credit) to the ex-spouse, based upon a percentage share of the 'cash equivalent transfer value' (CETV). A corresponding pension debit reduces the value of the former spouse's benefit.
Where the ceding scheme is a personal pension scheme, including a SIPP, the CETV is always transferred to a scheme chosen be the ex-spouse, usually another personal pension.
In cases where the pension is split, the pension share does not have to be 50/50 and if the parties are unable to agree, the split will be set by the court. In practice, the split of the pension value is likely to be unequal, so as to achieve a 50/50 split of the ultimate 'deferred income', due to the different life expectancies of males and females.
A word of warning
Since April 2006, there has been a 'lifetime allowance' that applies for tax purposes which is effectively the maximum amount of pension benefit that a member can accrue without attracting tax penalties. The situation may be exacerbated by the recent changes to tax relief on pensions for higher earners.
On divorce, there is no increase in the allowance for pension rights foregone which can, potentially, restrict an individual's ability to rebuild their pension rights after they have had to share a large pension pot with an ex-spouse, although this is likely to only affect those with sizeable pensions. Note that you can continue to contribute above this limit, but the tax benefits will be significantly reduced.
More from Sam Thewlis:
